The classic 60/40 portfolio is losing some of its prominent followers, having tumbled almost 17% in 2022 in its biggest annual drop in over a decade. And last month, BlackRock – the world’s biggest asset manager – became the latest investor to ditch the traditional portfolio, famed for its time-tested ratio of 60% stocks and 40% bonds. So here’s why – and what the investment giant recommends doing instead.

Why is BlackRock abandoning the 60/40 portfolio?

The whole draw of the 60/40 portfolio is the assumption that stocks and bonds are inversely correlated – that is, when the price of one falls, the other rises. But that’s not the case anymore, according to BlackRock. See, major central banks are hiking interest rates to dent economic growth and bring inflation down. In such a scenario, stocks and bonds are both likely to experience losses at the same time. That’s because the combination of falling economic growth and high inflation squash corporate earnings and, in turn, stock prices. And simultaneously, rising interest rates push bond prices lower. The graph below, which shows the average daily return of 10-year US Treasuries on days when stock prices fell, illustrates this new regime we’re in. You can see that since 2021, average bond returns have dipped alongside stocks.

The inverse relationship between stocks and bonds has broken down since 2021. Source: BlackRock

BlackRock also doubts that central banks would come to the rescue with rapid rate cuts if the economy does enter a recession. Instead, they’ll likely keep interest rates high until inflation decisively returns to their targets of around 2% – an effort that’ll take longer than investors expect, according to the asset manager. History backs up that claim. Consider an excellent study by Research Affiliates that looked at inflation surges in 14 developed countries over the past 50 years. Here’s what it concluded: when inflation crosses above 8% (the level reached in most of the developed world last year), falling back to 3% usually takes six to 20 years, with a median of over ten years.

What does BlackRock recommend investors do instead?

Against a backdrop of growing risks, from turmoil in the banking sector to heightened geopolitical tensions, BlackRock is advising investors to adopt a more agile approach. In practice, that entails adjusting strategic asset allocations more frequently in response to market shocks and emerging information. And by fine-tuning those asset allocations, investors could ultimately create more resilient portfolios. But that’s easier said than done, so let’s look at some of BlackRock’s more specific recommendations.

Stocks

Based on a tactical six to 12-month view, the firm favors defensive sectors – like healthcare and consumer staples – that are better placed to withstand a recession. Exchange-traded funds (ETFs) are a simple way to buy in, like the iShares Global Healthcare ETF (ticker: IXJ; expense ratio: 0.40%) and the iShares Global Consumer Staples ETF (KXI; 0.40%). But if you want to be more granular, BlackRock recommends digging into these sectors and selecting companies with robust cash flows, resilient supply chains, strong market shares, and the ability to pass on higher costs to customers.

Interestingly, so-called “smart money”, or big money managers, have also been pulling cash out of economically sensitive shares recently, parking it in stocks that are seen as more resilient during economic downturns instead. According to Bank of America data out this week, professional stock-picking hedge funds have cut their exposure to cyclical sectors – that’s those with performances tied to fluctuations in the economy – relative to defensive ones to the lowest level since at least 2012. And for traditional, long-only investment managers, their relative exposure to cyclical firms versus defensive companies is near its lowest level since 2008.

Professional investment managers have cut their exposure to cyclical sectors relative to defensive ones in anticipation of a recession. Source: Bank of America

Bonds

BlackRock expects inflation to stay stubbornly high, which is why it recommends that investors go heavy on inflation-linked bonds in their portfolios. These are bonds that see their principal and interest payments automatically rise and fall with the consumer price index. If you’re interested, the iShares TIPS Bond ETF (TIP; 0.19%) gives you exposure to inflation-linked bonds issued by the US government.

BlackRock also said that it prefers short-term government bonds over long-term ones for several reasons. First, with yields of over 4%, short-term government bonds now offer an attractive source of income. Second, they’re currently providing higher returns than long-term government bonds given that the yield curve is inverted at the moment. Third, shorter-duration bonds are far less sensitive to increasing interest rates, meaning their prices would decline considerably less than longer-duration bonds when rates rise. If you agree with BlackRock’s leaning, you can build exposure to short-term US government bonds with the iShares 1-3 Year Treasury Bond ETF (SHY; 0.15%).

So should you ditch the 60/40 portfolio too?

Not everyone agrees with BlackRock’s view. Vanguard, for one, recently told clients that the performance outlook of a global 60/40 portfolio over the next decade has improved significantly. In fact, the world’s second-biggest asset manager predicts a global version of the classic strategy will deliver annualized returns of 6.1% over the next decade. That’s up from a forecast of 3.8% made at the end of 2021, when the US stock market was trading close to an all-time high and the 10-year US Treasury yield was hovering at around 1.5%. And so far, the global 60/40 portfolio is already bouncing back this year, up by almost 7% as of the time of writing.

Vanguard reckons that the performance outlook of a global 60/40 portfolio over the next decade has improved markedly. Source: Vanguard

There’s also an economic reason why you shouldn’t bury the 60/40 strategy just yet. See, the current environment that’s pushing both stocks and bonds lower – remember, that’s falling economic growth coupled with rising rates and inflation – can’t last forever. In theory, the environment should normalize at some point in the future, causing the 60/40 portfolio to regain its diversification mojo. But when that’ll happen is anyone’s guess.

As with everything in life, it’s never just black or white. Realistically, if you're a long-term investor with an extended time horizon, the 60/40 portfolio can make for a sturdy starting point. And Vanguard is correct in saying that the strategy’s outlook has improved markedly now that stock valuations have come back down to earth and bonds are finally offering attractive yields. But if you share BlackRock’s concerns regarding the near-term outlook, which includes falling economic growth mixed with elevated interest rates and inflation, then you might want to adapt the 60/40 strategy to the current environment. To do that, BlackRock recommends investors overweight their portfolios with defensive stock sectors, short-term government bonds, and inflation-linked bonds.