Diversification is beneficial to a portfolio because it reduces risk. Risk cannot be completely reduced, and thus, investors try to balance the portfolio in such a way as to reduce risk and to still let the portfolio grow.
There are various ways to reduce the risk in a portfolio. One is hedging, but it is costly and requires a deep understanding of financial markets.
Another is to add assets that are not correlated or have a low correlation degree to your portfolio. Bonds and stocks complement each other because bonds provide stability to a portfolio, while stocks are more volatile.
But how much to allocate to each asset class? The 60/40 portfolio is a solution.
What is a 60/40 portfolio?
The 60/40 portfolio is made out of 60% stocks and 40% bonds. The idea is to minimize the risk while producing returns even if financial markets are in distress because there is a reduced correlation between the two asset classes.
2022 has been a tough year for the 60/40 portfolio, as it delivered a -24% return. However, such a portfolio had the best YTD performance ever, calculated as annualized returns after the first trading week in February.
So why would anyone build a 60/40 portfolio after such a poor performance in 2023? Here are three reasons in favor of the 60/40 portfolio:
The average annual return in over a century is +9.5%
Only two times in over a hundred years there were two consecutive years when the 60/40 portfolio delivered negative results
Needs only yearly rebalancing
How to build a 60/40 portfolio?
The simplest form of such a portfolio is to buy a stock index (i.e., an ETF that tracks a stock market index) and an ETF that tracks bonds.
S&P500 ETFs have total assets of about $1 trillion. Thirteen ETFs exist, and the average expense ratio is 0.6%.
As for the bonds ETF, one choice might be IEF, which stands for iShares 7-10 Year Treasury Bond and tracks the investment results of an index composed of US Treasury bonds with remaining maturities between seven and ten years.