Chart of the Week: What Follows a 10%-Plus Decline?

Jeffrey DeMaso

Portfolio Manager

By now, you are probably well aware that stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company. have had a rough first half of the year. But most investors are invested in a blend of stocks and bonds—so how have balanced portfolios fared in down markets like this one?

Pundits have pronounced the classic balanced portfolio dead for years. (Wall Street coined the term “policy portfolio” for strategies that allocate 60% of assets to stocks and 40% to high-quality bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. because it is the default for many endowments and pension funds.) But the requiem is growing louder due to dreadful recent performance. If the current calendar quarter had ended on Thursday, the 60/40 portfolio would be showing a loss of 15.1% for the year. Outside of the global financial crisis, you have to look back to 1974 to find a six-month period where a balanced investor was down that much.

This has led to the conclusion that the efficacy of blending stocks and bonds into a balanced portfolio is a dead end. I’m not jumping to that conclusion. I’m also willing to give the classic 60/40 policy portfolio a rethink. But if you’ve been invested in a diversified portfolio over time, let me suggest that now may be precisely the wrong time to steer in a new direction.

I looked at rolling six-month returns for the 60/40 portfolio going back to 1945 and identified every period with a 10% or greater decline—there were 15 of them, not including the first half of this year. On average, the classic balanced portfolio gained 10% over the next six months and was negative only once. If you look out over 12 months rather than six, the 60/40 portfolio was higher every single time, with an average return of 18%.

As the disclaimer says, past performance is no guarantee of future results. We can’t change the past, of course, but we can try our best to position our portfolios for the road ahead. A lot of pain has already been handed out in both the stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. and bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. markets this year. Historically, returns have been attractive following periods like the one we are currently going through.