Will the 60/40 portfolio bounce back in 2023?

The 60/40 asset allocation has been a staple in stock and bond portfolios for decades but clearly fell short in 2022. Forty-year high inflation led to rising recession risk and a hawkish federal reserve. In its battle to slow inflation, the Federal Reserve raised interest rates at the most aggressive pace in history.

Despite strong earnings and healthy consumer and corporate balance sheets, stock market investors were not rewarded in what became a painful past year.

To make matters worse, bonds had their worst performing year on record. Simply put, bonds failed to protect against falling stock prices in any meaningful way causing the commonly used balanced approach to struggle throughout the year. A 60/40 portfolio, invested 60% in the S&P 500 Index and 40% in Barclays Aggregate Bond Index, lost more than 16% in 2022.

Bear markets in equities are common and happen from time-to-time. But historically, when stocks fall, bonds go up in value since investors are looking for safety. This "flight to quality" increases demand for bonds. Increased demand is particularly good for bond prices and fairs well for fixed income held in a portfolio.

In 2022, the surge for bond purchasing did not occur as during the year they were losing as much value as the overall stock market. This caused panicky investors to bypass bonds altogether and seek liquidity in money markets. Not only were investors not buying bonds, but many were selling as the Federal Reserve increased the Federal Funds rate from 0.25% to start the year to 4.5% by the end of December.

While it was a difficult year for the 60/40 portfolio, it is important to remember although a diversified portfolio of stocks and bonds often work well together, there are rare and occasional years that they do not.

Illustrated in the following chart, since 1930, there have only been 12 years in which a 60/40 portfolio finished with negative returns, 2022 ranking as the third worst.

Although many investors fear a retest of the stock market lows, or even lower lows of 2022, we are hopeful that markets can bounce back for a positive year in 2023. We believe the biggest reason for this will be falling inflation. Here are the past seven months of monthly Consumer Price Index (CPI) reports: 9.1%, 8.5%, 8.3%, 8.2%, 7.7%, 7.1% and 6.5%.

As inflation slows, less pressure will remain on the Federal Reserve to continue its aggressive pace of interest rate hikes. All else being equal, that'll likely be a win for the economy, stock and bond markets.

While a diversified approach of the 60/40 portfolio does not work every time, history shows us that it has worked over time. Regardless of what happens to stocks and bonds this year, investors should stay committed to their overall investment plan, remaining focused on their goals, time horizon and cash flow needs.

• Jim Platania Sr., CFP® is the President of Platania Financial Inc., located at 2 W. Northwest Highway, Arlington Heights, IL 60004. He can be reached at info@plataniafinancial.com or by phone at (847) 870-7526. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. The Bloomberg Barclays U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds. Securities and advisory services offered through LPL Financial, a registered investment advisor. Member FINRA/SIPC.