Many plan sponsors allocate their pension assets to a portfolio of 60/40 global stocks and bonds. More sophisticated plans use variations of a 60/40 portfolio, as they substitute private equity, real estate and other hard assets, or hedge funds in place of public equity or fixed income exposure. Why do these plan sponsors and their advisors design a policy portfolio with that target in mind? Asset allocation is by far the most important investment decision for many investors. Each year, plan sponsors devote a significant amount of consideration and resources to traditional asset allocation studies, starting from asset return forecasts and risk estimation, followed by portfolio construction with a combination of quantitative methods and qualitative tilts. Yet, irrespective of investment environment changes over time, it seems that the popularity of 60/40 portfolios continues to persist. Why? We offer a potentially simple explanation. In order to achieve a targeted nominal return, based on a reasonable set of capital market assumptions and budget constraints, one only has to have sufficient investments in stocks and other risky assets. Hypothetically, if the return target is 8%, and if the expected return for stocks is 10% (higher than 8%) and the expected return for bonds is 5% (lower than 8%), a 60/40 portfolio would meet the target with an annualized standard deviation of 10%, and anything else with less exposure to stocks would not yield 8%. Is there anything wrong with a 60/40 portfolio then? Why is the ubiquitous 60/40 widely known as a balanced portfolio? Millions of investors clamor for balanced funds. If it is labeled “balanced,” it must be diversified, and based on its 60/40 capital allocation it is just that.
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