Published On: November 23, 2021
Written by: Ben Atwater and Matt Malick
Given ultra-low interest rates and lofty equity valuations, various experts and financial journalists are questioning the future of a traditional “balanced” portfolio of 60% stocks and 40% bonds.
For decades, the 60/40 portfolio has been the default allocation for all kinds of investors from retirees to endowments. The results for a balanced portfolio have been nothing short of excellent over the last 30 years. Not only have stock prices risen, but so have bond prices (as interest rates fall, bond prices rise).
The balanced portfolio has a certain intuitive beauty to it. The mix favors growth (stocks) at 60%, while devoting a meaningful chunk to stability (bonds) at 40%.
When you think about a balanced portfolio from a risk perspective, if stocks encounter a severe bear market and fall 50% and bonds stay flat, your portfolio will lose 30%. This is a powerfully simple visualization exercise and stress test for investors.
In cases when the stock market falls markedly, high quality bonds usually rally, providing a boost to balanced portfolios. So, if the bond allocation rallies 15% when the stock allocation falls 50%, the balanced portfolio would lose 24%. Meanwhile, an all-equity portfolio would – obviously – lose 50%. In other words, a 60/40 portfolio may carry less than half the risk of an all-stock allocation (down 24% versus down 50%).
The recent dustup over balanced portfolios does not stem from risk, but rather from return. Just consider the return problem.
Looking to the stock side of the equation, recent analysts’ estimates for the forward earnings yield (the inverse of the price-to-earnings ratio) for the S&P 500 is 4.5%. If we use this as a proxy for future equity returns, a 60% stock allocation could expect to contribute 2.7% per year to future portfolio returns.
Now turning to the bond side, with the ten-year U.S. Treasury recently yielding 1.63%, a 40% bond portfolio allocation could expect to contribute as little as 0.65% per year to the overall portfolio.
If we combine these two, a 2.7% stock portfolio contribution plus a 0.65% bond portfolio contribution, you get a potential expected return of a meager 3.35% per year. If inflation persists at the rapid pace of the last few months, investors could suffer long-term losses in real terms.
Some analysts see this as a severe crisis that will impact endowments, pensions, and retirement accounts for years to come.
This “return crisis” is leading portfolio managers to add various other asset classes to enhance returns. The list of “alternative” asset classes is long, including preferred equity, private debt, real estate, private equity, special situation bonds, hedge funds, derivatives, gold, cryptocurrencies, non-fungible tokens, etc. Interestingly, this same trend was under way in the mid-2000s as well.
“Diversifying” into other asset classes seems to make sense on the surface, however, it is not quite so easy. Like many other investment decisions (such as market timing) you need to be correct twice.
First, you need to be correct that the traditional balanced portfolio will underperform. Second, you need to choose the correct “alternative” asset classes (not to mention the correct asset class managers) that will outperform the balanced portfolio.
We saw a similar rush to “diversification” in the mid-2000s. Back then, money managers were worried more about risk (i.e., volatility) and less about return. Today, we perceive it as the other way around, with managers worried too much about return and not enough about risk.
Ironically, from the mid-2000s to now, by posting higher returns and lower risk, the balanced portfolio has triumphed over more sophisticated and complex investment options.
The argument for the balanced portfolio underperforming over the next decade seems solid enough, but it ignores some major areas like the relative bargains available in value, international and emerging market stocks. It also ignores the fact that interest rates could again tumble even lower and further boost bond prices (and, therefore, the total return of a balanced portfolio). Finally, and most critically, the argument ignores the power of rebalancing during times when stocks or bonds underperform.
We do not know the levels of risk and return that balanced portfolios will produce in the coming years. But we do know that the longer interest rates stay around zero, the higher the probability that money will drift to some strange places. We will resist the temptation and stick to the tried and true.