When the future is uncertain, diversification is key. This has been the mantra of many an investor, and particularly those who favour a so-called 60/40 portfolio (one which is 60% stocks and 40% bonds). Also known as a balanced portfolio, this is the bedrock of a number of strategies adopted both by professional and individual investors around the world.
But this strategy is not without risk, prompting some investors to question the interest of this approach and ask: do balanced portfolios outperform?
During the first quarter of 2020, a US investor with a simple 60/40 would have suffered one of the largest drawdowns since the 60s, according to a Goldman Sachs research report published in April. “This followed a decade of very strong risk-adjusted returns for balanced portfolios, supported by a combined bull market in equities and bonds, but negative equity/bond correlations”, the report says.
And even though this balanced portfolio had a difficult first quarter in 2020, its returns subsequently improve as outperformance of equities (on a global basis) has outweighed poorer returns from bonds. Jason Kephart, senior analyst at Morningstar, recently says: “Ironically for the 60/40 doomsayers, those same factors that caused interest rates to spike also spurred strong stock returns that more than outpaced the losses in the bond portfolio.”
Not a Typical Economic Recovery
This might not come as a complete surprise. In a typical economic recovery, the yield curve tends to steepen, and equity returns usually improve.
Yet the fact that both bond and equity markets are expensive might puzzle some investors. When valuations are high for both asset classes, prospective future returns are low and the risk of drawdown potentially increases. The crash of financial markets last year was a painful illustration of this in action.
This puzzling environment has been around for some time now. Therefore, isn’t there a risk of a higher correlation between bonds and stocks that would undermine a key attraction of a balanced portfolio?
Year after year, the very low interest rate environment created by central banks has forced many investors to increase their exposure to risk in a bid to find more decent returns. Some investors even have traded risk for illiquidity and turned to alternative asset classes such as private equity, real assets (such as infrastructure), higher-yielding asset fixed income options (high yield, emerging debt) or fancier but riskier assets such as cryptocurrencies.
“This temptation to increase exposure to less liquid asset classes in order to find income and compensate for the lower yield of traditional asset classes is risky”, says Clemence Dachicourt, a senior portfolio manager with Morningstar Investment Management Europe. “Over time, bonds have shown they still can play a role in diversifying risk and be a safe haven for portfolios”, she adds.
Don't Forget to Diversify
The point of the 60/40 portfolio is that it is balanced, and that if one part of the portfolio is having a poor run, the other side should make up for it. This is something that has played out for investors time and time again. “The first quarter of 2021 showed that even the worst quarter for US investment-grade bonds in the last 20 years wasn't enough to derail the classic 60/40 portfolio”, says Kephart.
So what’s the conclusion for investors? As long as correlation between traditional asset classes doesn’t shift dramatically, holding a 60/40 portfolio still makes sense.
That doesn’t mean investors should not consider some alternative asset classes, but it is likely better to hold such things in the margins and keep the core of your portfolio in more vanilla stocks and bonds. Diversification, remember, doesn't just mean spreading your money across lots of different types of asset, it can be found within stocks and bonds, by investing in different regions, sectors and market capitalisations.
The most important risks any investor should always have at front of mind is the permanent loss of capital and the loss of purchasing power (something that is particularly important at the moment as investors prepare for rising inflation). As long as the 60/40 portfolio fits the bill, which as been the case so far, it is still relevant.
