by David Robertson, CFA
June 2020
If ever there was a mantra in the investment world it is that you have to diversify. Everyone knows that combining uncorrelated assets into a portfolio reduces the risk of destructive drawdowns. For several decades now the iconic way to realize diversification in investment portfolios has been through a balance of 60% stocks and 40% bonds (60/40).
This approach has worked brilliantly and has allowed countless investors to comfortably sit back and watch their retirement dreams come true. Unfortunately, those halcyon days are coming to a close. It is time for investors to start considering alternative ways to balance their portfolios.
There is no doubt that the 60/40 model has worked. Phil Lynch of Russell Investments, for example, shows that between 1926 and 2019, "a balanced 60/40 global stock/bond portfolio has provided competitive returns ..." The Financial Times adds: "A US 60-40 portfolio in the decade to 2020 produced its highest volatility-adjusted returns in over a century, according to investment bank Goldman Sachs."
There is a caveat, however, and it is one that many providers of investment services use to make a point. Those attractive returns have only been "for investors who stay invested during turbulent markets." The message is that if you even so much as think about getting out of the market, you risk forfeiting extremely attractive returns.
To be fair, it is not a good idea to jump out of the market at just any little hint of turbulence. But nor is it a good idea to assume that the landscape never changes, and that risk and reward are static. Indeed, a great deal of evidence is accruing that now is exactly the time investors and advisors should be carefully re-assessing the strengths and weaknesses of the 60/40 strategy.
For starters, the historical performance of the 60/40 portfolio is considerably less robust than it first appears. Chris Cole from Artemis Capital Management points this out in a terrific piece of research entitled The Allegory of the Hawk and Serpent (h/t Grants Interest Rate Observer) He highlights that "A remarkable 91% of the price appreciation for a Classic Equity and Bond Portfolio (60/40) over the past 90 years comes from just 22 years between 1984 and 2007." In other words, the performance for other periods of time was much less impressive.
In addition, further cracks in the case for the 60/40 appeared earlier this year. According to the FT, "the 60-40 strategy suffered one of its worst performances since the 1960s, as the bond rally proved insufficient to offset the tumble in stocks." While instances of bad performance happen, and stocks were certainly part of the problem, it was especially unsettling that bonds did not do their job this time around.
The monetary policy response to Covid-19 in the first quarter also exacerbated challenges. The FT added:
June 2020
If ever there was a mantra in the investment world it is that you have to diversify. Everyone knows that combining uncorrelated assets into a portfolio reduces the risk of destructive drawdowns. For several decades now the iconic way to realize diversification in investment portfolios has been through a balance of 60% stocks and 40% bonds (60/40).
This approach has worked brilliantly and has allowed countless investors to comfortably sit back and watch their retirement dreams come true. Unfortunately, those halcyon days are coming to a close. It is time for investors to start considering alternative ways to balance their portfolios.
There is no doubt that the 60/40 model has worked. Phil Lynch of Russell Investments, for example, shows that between 1926 and 2019, "a balanced 60/40 global stock/bond portfolio has provided competitive returns ..." The Financial Times adds: "A US 60-40 portfolio in the decade to 2020 produced its highest volatility-adjusted returns in over a century, according to investment bank Goldman Sachs."
There is a caveat, however, and it is one that many providers of investment services use to make a point. Those attractive returns have only been "for investors who stay invested during turbulent markets." The message is that if you even so much as think about getting out of the market, you risk forfeiting extremely attractive returns.
To be fair, it is not a good idea to jump out of the market at just any little hint of turbulence. But nor is it a good idea to assume that the landscape never changes, and that risk and reward are static. Indeed, a great deal of evidence is accruing that now is exactly the time investors and advisors should be carefully re-assessing the strengths and weaknesses of the 60/40 strategy.
For starters, the historical performance of the 60/40 portfolio is considerably less robust than it first appears. Chris Cole from Artemis Capital Management points this out in a terrific piece of research entitled The Allegory of the Hawk and Serpent (h/t Grants Interest Rate Observer) He highlights that "A remarkable 91% of the price appreciation for a Classic Equity and Bond Portfolio (60/40) over the past 90 years comes from just 22 years between 1984 and 2007." In other words, the performance for other periods of time was much less impressive.
In addition, further cracks in the case for the 60/40 appeared earlier this year. According to the FT, "the 60-40 strategy suffered one of its worst performances since the 1960s, as the bond rally proved insufficient to offset the tumble in stocks." While instances of bad performance happen, and stocks were certainly part of the problem, it was especially unsettling that bonds did not do their job this time around.
The monetary policy response to Covid-19 in the first quarter also exacerbated challenges. The FT added:
"Covid-19 has brought us to a historic turning point in financial markets. A fundamental investment strategy that has protected institutional and retail investors alike for decades — balancing equity risk by holding high-quality government bonds — has finally run its course. When the Fed lowered short-term rates to zero in response to the pandemic, the last shoe dropped."
In retrospect, it is easy to see why bonds provided such a powerful combination with stocks. Not only did investors receive insurance in the form of diversification benefits, they also got paid for having that insurance by receiving coupons. It was one of the exceptionally rare instances in which investors got to have their cake and eat it too.
That blissful situation has changed, however, and the FT goes on to describe how:
That blissful situation has changed, however, and the FT goes on to describe how:
"Now that double benefit has turned into double jeopardy. As main central banks have lowered interest rates towards zero over the past decade, the yield component of the return on a portfolio of government bonds has evaporated. That leaves capital appreciation as the sole source of future returns. But the room for prices to rise has arguably all but disappeared too."
Investors must now face the music. Their beloved and productive 60/40 strategy can no longer accomplish what it has accomplished for so long. It will be missed.
"For investors who hold the classic 60/40 portfolio, this is a disaster. They have lost a reliable source of return and their diversification strategy is broken."
This quandary is raising questions by investors of all types. Rusty Guinn from Epsilon Theory reports, "What is fascinating to me is that within a week, a professional market research shop, a personal finance writer and a financial markets journalist all took on the question of 'the role of bonds'."
"But I can observe that enough people are thinking about it – and enough people know that other people are thinking about it – that common knowledge is forming around the question."
In other words, the issue of the role of bonds is becoming a thing. It is certainly a thing among fund managers as the FT notes:
"Investors are now grappling with the implications. In Bank of America’s investor survey in March 52 per cent of fund managers said that US government bonds were the best hedge against turmoil. That share dropped to 22 per cent in April."
The fact that the role of bonds is being discussed is good news in the sense that the industry is adapting. However, it also means that if you are not working through these things yourself, you are falling behind the curve.
More is needed than just discussion though. Specific alternatives need to be identified to take the place of the diversifying role of bonds. The FT offers some suggestions, some of which are simple and some of which are a lot more complicated:
More is needed than just discussion though. Specific alternatives need to be identified to take the place of the diversifying role of bonds. The FT offers some suggestions, some of which are simple and some of which are a lot more complicated:
"In seeking new sources of ballast for balanced portfolios, asset allocators will have to think about alternatives to bonds, including cash, gold, cryptocurrencies, and explicit volatility strategies — such as put options directly hedging equities — with which they may be less familiar. There are pros and cons to each selection, but the key point is that, with the diversifying power of bonds gone, there is no longer any natural choice."
These ideas are extremely helpful in framing out possible replacements for bonds in balanced portfolios. Expectations ought to be managed though. Not only are these replacements unlikely to provide the same types of returns that bonds have, but they are less likely to provide the same diversifying effect as bonds have as well. On top of all that, some of these options are going to be unfamiliar and uncomfortable for some investors.
While the days of the 60/40 strategy appear to be numbered, the more general lesson to keep in mind is that things always change and therefore it is important to remain flexible and open-minded in order to deal productively with those changes. As John Hussman explains, these traits are likely to be extremely important in dealing with investment challenges ahead:
While the days of the 60/40 strategy appear to be numbered, the more general lesson to keep in mind is that things always change and therefore it is important to remain flexible and open-minded in order to deal productively with those changes. As John Hussman explains, these traits are likely to be extremely important in dealing with investment challenges ahead:
"That ability to respond to changing market conditions in a disciplined way is the one thing that passive buy-and-hold investors don’t have, and I strongly believe that it’s the primary factor that will determine investment success over the coming decade. Lacking a flexible discipline, my view is that passive investors are doomed to go nowhere in an interesting way over the coming 10-12 year horizon."
So, it's never easy to replace something that has worked well for a long time. In this sense, replacing the 60/40 strategy is like bidding farewell to a star athlete who is retiring. We can all remember and respect the terrific accomplishments of the past, but also recognize that younger players are now more capable of competing at the highest level. Overly sentimental attachments will prevent progress; it is best to make the change and move forward.
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