Is the 60:40 equity-bond allocation model still viable in today's market?

Synopsis

The popular 60:40 equity:bond portfolio strategy, successful in the past decade due to low interest rates, now faces challenges. Rich share valuations, persistent inflation, and geopolitical uncertainties, including AI's impact, demand a re-evaluation. Investors should consider diversifying beyond equities as valuations suggest lower returns compared to safer fixed-income options, potentially avoiding a prolonged period of market stagnation.

Mumbai: The 60:40 or 70:30 equity: bond allocation-among the most widely recommended and followed portfolio models these days-has been the most effective, lucrative risk-adjusted investment strategy in the past decade or more. But what began as a sensible investment philosophy years ago in an era of cheap money and low bond yields may have ossified into lazy consensus, overlooking simmering risks such as rich share valuations, a longer-than-expected higher interest rate environment and ever-shifting economic dynamics.

Muscle Memory

For investment advisors and individual investors who have been in the market for the past decade, the 60:40 or a 70:30 allocation model has become muscle memory. It's based on the assumption that equities are bound to deliver outsized returns, while the rest of the portfolio is meant to bring stability. Back-tested return models favour this outcome, while mutual funds and distributors have a clear incentive to push equity products, which earn them higher fees, skewing the tilt toward the stock market. Moreover, the global macroeconomic conditions-mainly persistently low interest rates-encouraged higher risk-taking that supported the case for going all out on equities.

All that has changed. Central banks, mainly the US Fed, are struggling to find enough reasons to cut interest rates in the face of sticky inflationary pressures, while Donald Trump's tariffs are threatening to upend the global economic order that investors have been used to. Moreover, policymakers, corporates and investors are grappling with a bigger unknown: AI and its effects.

Valuation Risks
The risk lies in the disconnect-economic conditions are shifting but the portfolio allocation strategies remain stuck with a heavy bias toward equities. What's more, market valuations provide little comfort to allocate money aggressively to equities. The estimated price to earnings (PE) ratio-a popular valuation measure-of the Nifty is at more than 22 times, against the 10-year average of about 20, suggesting these are above long-term averages.

The equity risk premium-the extra return investors expect from equities over a risk-free asset-also does not favour excessive risk-taking in the stock market. The gap between equity returns and safer alternatives like fixed deposits has turned negative, suggesting stocks have become too expensive. At a PE ratio of 22 times, the Nifty offers an earnings yield of about 4.5%. In contrast, top-rated SBI's fixed deposits return around 7.2%. That means investors are earning less from equities than from risk-free options.

Essentially, investors are being overweight on equities, when the cushion is the thinnest or is missing. Such a strategy stems from the perception that valuations do not matter if investments are being made for the long term as buy-on-dips has mostly worked in the past decade. Thus, the default setting of 60-70% allocation to equities has settled into a lazy consensus.

60:40--Conviction or Ease?
This strategy has become muscle memory for a wider section of investors not out of conviction but because it's easy.

Why would anyone want to shake up a system that has worked well for so long. Much like in cricket-where the captain and the coach are unwilling to tinker with a winning combination-investment advisors and investors too prefer to stick to an equity-heavy portfolio that has worked wonders for them in the recent past, despite shifting conditions.

All this is not to suggest that equities are set to crash soon or are about to slip into a bear zone. Elevated valuations have never been strong indicators to signal the market top, but they are credible enough to remind investors to tread carefully. Investors usually associate market risks with a bear phase when stocks drop like ninepins. But there is another possibility that could be as painful: a long grinding stretch of return-free markets.

One such episode was the period from 2000 to 2010, when the US markets hardly made any returns, a phase dubbed as the 'lost decade' for the world's largest economy. This happened after the 2000 dotcom bust, a stark reminder to investors that a prolonged market stagnation could happen to the strongest of the economies. In such a situation, it's the boring, traditional sources such as dividends and fixed income market that keep portfolios ticking.

There are no indications that Indian equities are headed for a similar fate, but elevated share valuations and shifting global dynamics certainly warrant some toning down of optimism in the stock market and a more diversified portfolio.

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