Whether one invested in long-dated bonds, Tesla stock, or with FTX, 2022 provided a sobering reminder that economic regimes change. Even the stalwart 60/40 portfolio had one of its worst years ever. A look under the hood of what drives asset class performance makes clear that the only surprise is that it took so long for 60/40 to crack. The question for investors: what provides a better alternative?
The 60/40 portfolio has a logic to it, as equities drive performance while bonds offer diversification in periods of recession or market stress. Its simplicity hides two significant problems, though. The first is that equities are substantially more volatile than bonds, and so in a portfolio with 60% in equities, stocks contribute more than 90% of the risk. The second is that high inflation, which leads the Federal Reserve to raise interest rates and decreases the value of the future cash flows promised to equity holders, punishes both stocks and bonds, something especially painful when there is nothing else in an investor's portfolio to cushion the blow.
When constructing a portfolio, investors should instead focus on balancing their investments to weather different economic situations. As the recent results of the 60/40 portfolio have shown, investors need more than stocks and bonds, because those asset classes may all end up moving in the same direction during certain market conditions, providing insufficient diversification and, indeed, risking loss of capital. Diversifying across multiple asset classes that perform in both inflationary and deflationary periods, as well as high and low economic growth ones, can lead to a more stable portfolio with a higher level of potential return per unit of risk.
Twenty years ago, this concept came to be called "risk parity." Today, the term offers little but frustration to individual investors. The label itself has become meaningless, as investment managers now use it to refer to almost any strategy that is sold as balancing risk across different sources of return, but not necessarily across different economic environments. Regardless of the label, however, a portfolio balancing risk depending on varying economic conditions should be appealing to both taxable individuals and tax-exempt institutions.
Investors were lucky that for the past several decades, declining inflation and falling interest rates made a 60/40 portfolio appear consistently attractive. As 2022 proved, however, including assets that do well in an inflationary regime, such as inflation-linked bonds, energy, and commodities, can provide critical ballast to the performance of stocks and bonds: comparing the Bloomberg Commodity Index's 2022 return of +16% to the Bloomberg Aggregate's —13% illustrates this point. By further refining the strategy to focus on after-tax returns—such as employing municipal bonds in place of Treasuries—the result can be a portfolio that, in a relatively tax-efficient manner, could offer attractive returns across different market environments.
For investors, the adjustment to a dynamic asset allocation that integrates macroeconomic analysis and a more expansive definition of asset diversification is a departure from the recent past. After all, during the last decade, the 60/40 portfolio was propped up by low inflation and low bond yields, which caused equities to be the best-performing asset class. Any effort to diversify away from equities was, with the benefit of hindsight, a mistake. As a consequence, investors, who often have a fear of missing out and a tendency to drive by looking in the rear-view mirror, over-concentrated in equities, especially growth and technology companies.
Today the macroeconomic landscape looks quite different. Expected returns across all asset classes look highly attractive as of year-end 2022. For example, 10-year real yields have risen to 1.6% at the start of 2023 from -1% at the beginning of 2022, which means that those holding inflation indexed bonds are receiving yields not seen since before the 2008-09l financial crisis. Commodities are currently in the midst of a substantial supply shortage and potential demand resurgence following a decade of poor performance and a lack of investment in the industry. Finally, fixed income securities across the globe, including in Europe, Canada, and emerging markets, are trading at some of the highest yields of the past two decades.
But more attractive valuations do not mean we should return to the simplistic asset allocations of the past. Investors should instead reflect on their tolerance for volatility and their own ability to predict the future. For extended periods of time a particular economic regime can dominate.
For most of the past decade, investors experienced solid growth, low inflation and falling interest rates. On the other hand, in the 1970s, inflation dominated. As the past 18 months have shown us, the success of the 60/40 portfolio rests on the global economy returning to the benign market environment of the past 10 years. What will the next paradigm be and how long will it last?
Will growth or inflation be the driver of market returns? As the great Yogi Berra is credited with saying: The future ain't what it used to be. Investors now have access to a deeper and broader range of assets to employ in building diversified, more durable, and tax efficient portfolios. It's time to leave 60/40 behind for something better.
