Over the long term, equities have the potential to generate a high inflation-adjusted return. Bonds, on the other hand, are a less-volatile asset class that provides a consistent return over the short-to-medium term. A prudent investing principle considers exposure to both equity and debt to be a better approach. Traditionally, a 60/40 portfolio with 60% exposure to equity and 40% exposure to debt is the most popular and widely followed investment strategy by investors worldwide.
Investing 60% of one’s portfolio in stocks and 40% in bonds is supposed to protect against both assets falling at the same time. But that did not happen in 2022. Inflation and rising interest rates harmed both asset classes.
DSP Investment Managers in its annual note – 2023, “It’s a relative world” takes a look at the performance of such a portfolio. The classic 60/40 portfolio, which consists of 60% stocks and 40% bonds, has been a successful investment strategy that offers both growth potential from equities and capital protection from bonds. However, a 60/40 portfolio (consisting of 60% US large-cap stocks and 40% US long-term treasury bonds) suffered a 22% loss in 2022, the second-largest loss on record and the largest since 1931.
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The fall in equity values as well as bond prices in 2022 could be attributed primarily to the US Fed’s policy. The note identifies how Fed policy remained a key determinant of returns across asset classes. In 2020 and 2021, the Federal Reserve implemented aggressive monetary easing policies that led to a significant increase in nominal spending, exceeding the output capacity of the labour market and leading to supply-side pressures.
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This resulted in high inflation, which prompted the Fed to raise interest rates. In 2022, higher interest rates and tightening of monetary policy led to a sharp correction in asset prices. The Fed’s tightening measures to control inflation were among the most severe in the past 60 years.