The myth of the traditional 60/40 portfolio

Dan Miles

Innova Asset Management

A lot is spoken about when it comes to correlation. We hope to break this down and explain what some of the investment jargon means, look at mistakes even the most seasoned professionals make, and the history of why they make those mistakes. 

Correlation is the concept of how one, or a series or assets move in conjunction with each other. If an asset moves up 1% one day, down 0.5% the next day, up 2% the following day and 0% the following day, then another asset that follows the same pattern would be said to have a perfect correlation or a correlation of 1 (meaning 100%). If instead an asset did the reverse, went down 1%, up 0.5%, down 2% then 0% on the final day, it would be said to have a perfect negative correlation of -1 (meaning -100%).

However, there’s more to it than that. In investing we also have the concept of beta. If an asset moved up .5%, down .25%, up 1% then 0% the last day – it would also be perfectly correlated. That is because the strength of the relationship between the relative movements between the assets is still 1 – it’s just that the second asset has a beta of 5, or 50%, to the first asset.

So, what’s the big deal with correlation? Well, in 1952 Harry Markowitz showed that the combination of less-than-perfectly correlated assets can lead to:

    1. A better returning portfolio for the same volatility or
    2. The same return for less volatility (here volatility was used as a proxy of risk – one we think is incomplete and often misleading).

However, this was ground-breaking work and won him a Nobel prize. The portfolio became known as the ‘optimal risky portfolio’ or ORP for short – and existed on something called the ‘efficient frontier’, crossing with something called the ‘capital allocation line’ which all finance professionals learn about in university and advanced finance courses – it consisted of 60% US equities and 40% US bonds based on the historical data to date. This was the genesis of the modern balanced portfolio or 60/40 portfolio.

A couple of things here. This 60/40 portfolio was taken as gospel, but by Harry Markowitz’s own statement in the paper, he is only concerned with the second phase of portfolio construction – that is using the forecast return, risk, and correlation of assets. The first stage is techniques in forecasting those very numbers! If you use incorrect numbers, you can’t have an optimal portfolio – and how can the past be a perfect predictor of the future? From the final two paragraphs of his paper:

I believe that better methods, which take into account more information, can be found. I believe that what is needed is essentially a "probabilistic" reformulation of security analysis. I will not pursue this subject here, for this is "another story." It is a story of which I have read only the first page of the first chapter. In this paper, we have considered the second stage in the process of selecting a portfolio. This stage starts with the relevant beliefs about the securities involved and ends with the selection of a portfolio. We have not considered the first stage: the formation of the relevant beliefs on the basis of observation*.

This is extremely important. History will not repeat. It may be similar, but the past will not be identical to the future. Therefore, using historical data to ‘optimize’ a portfolio must, by definition, lead to a non-optimal portfolio because the future results will be different to the past.

Here’s an easy way to understand it – future risk can be forecast using probabilistic methods (as suggested by Markowitz himself) with the highest degree of accuracy, but not perfectly. Future return can also be predicted somewhat (more accurately for some assets, greater variability for others), but not perfectly and again requires probabilistic methods. Finally, correlation is the least forecastable element. To develop a perfect portfolio you must forecast risk, return and correlation perfectly – which is impossible. Correlation alone is highly variable over time. 

The proliferation of conservative 30/70 portfolios and 85/15 portfolios prove it further. His 60/40 represented the ORP – one that had the best return per unit of risk (or volatility). If you wanted higher risk for the same risk/return, you needed to leverage the 60/40 portfolio, and lower risk involved adding cash to the portfolio while still maintaining the 60/40 equity/bond proportions. This is what it means to move out the efficient frontier. To change the mixes involved reducing the risk/return profile of the portfolio – something the mainstream market does routinely.


We believe that Harry Markowitz's work was both genius and extremely insightful – however, the investment world has forgotten something; his work implied the use of diversification to reduce risk, not to promote the 60/40 portfolio.

As explained by Harry Markowitz himself, the 60/40 portfolio was only optimal in 1952, in the US and in hindsight. We can surely do better now.

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Important Information This document has been prepared by Innova Asset Management Pty Ltd (Innova), ABN 99 141 597 104, Corporate Authorised Representative of Innova Investment Management, AFSL 509578 for provision to Australian financial services (AFS) licensees and their representatives, and for other persons who are wholesale clients under section 761G of the Corporations Act. To the extent that this document may contain financial product advice, it is general advice only as it does not take into account the objectives, financial situation or needs of any particular person. Further, any such general advice does not relate to any particular financial product and is not intended to influence any person in making a decision in relation to a particular financial product. No remuneration (including a commission) or other benefit is received by Innova or its associates in relation to any advice in this document apart from that which it would receive without giving such advice. No recommendation, opinion, offer, solicitation or advertisement to buy or sell any financial products or acquire any services of the type referred to or to adopt any particular investment strategy is made in this document to any person. All investment involves risks, including possible delays in repayments and loss of income and principal invested. Any discussion of risks contained in this document with respect to any type of product or service should not be considered to be a disclosure of all risks or a complete discussion of the risks involved. Past performance information provided in this document is not indicative of future results and the illustrations are not intended to project or predict future investment returns. Although non-Fund specific information has been prepared from sources believed to be reliable, we offer no guarantees as to its accuracy or completeness. Any performance figures are not promises of future performance and are not guaranteed. Opinions expressed are valid at the date this document was published and may change. All dollars are Australian dollars unless otherwise specified.

Dan Miles
Managing Director & Co-CIO
Innova Asset Management

Dan is the Managing Director & Co-CIO of Innova Asset Management, a boutique asset consultant and investment manager specialising in multi-asset, diversified investing with a particular focus on managing risk to create robust portfolios for clients.

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