The tried and tested 60/40 formula for long-term investment portfolios is off to its worst start since World War II.
The 60/40 portfolio – split between the S&P 500 index of stocks (60%) and 10-year US Treasuries (40%) – fell about 20% in the first half of 2022, the biggest drop never recorded for the start of a year, according to Goldman Sachs Research. These “balanced” portfolios, intended to combine the higher risk of equities with the relative safety of government bonds, often have different formulations, such as a mix of corporate credit or international equities. But virtually all of them had one of their worst starts to the year, according to Christian Mueller-Glissmann, head of asset allocation research in portfolio strategy at Goldman Sachs.
Almost all assets were in a precarious position at the start of the year, with stock and bond valuations hovering around their highest levels in a century, says Mueller-Glissmann. Decades of subdued inflation allowed central banks to lower interest rates to try to smooth out the business cycle, pushing up assets from equities to house prices. In fact, in the decade before the COVID-19 crisis, a simple US 60/40 portfolio produced three times its long-term average for risk-adjusted returns.
And then 2022 hit. As consumer prices and wages accelerated, central banks like the Federal Reserve rushed to reverse their policies. This resulted in one of the largest increases ever in real yields (bond yields minus the rate of inflation). As policymakers try to contain soaring inflation, stock market investors are increasingly concerned that such efforts could slow growth, which could tip major economies like the United States into recession. Indeed, investor concerns have recently shifted from inflation to recession-related concerns as inflation expectations have fallen, but it may be too early to mitigate inflation risks, at least in the medium term. term, according to Mueller-Glissmann.
“Unlike the last cycle, you had a mixture of growth and inflation conditions that are quite hostile,” says Mueller-Glissmann. Rising inflation weighs on bonds, as does tighter monetary policy (when central banks raise interest rates). It also means weaker growth, which is a headwind for equities, and equity valuations are also hurting from rising rates. “It’s a very bad backdrop for 60/40 portfolios, regardless of valuations,” he said.
This means there is less potential for diversification between equities and bonds, as they have been more positively correlated this year – in fact, this has been the case more often than not historically.
A funny thing about the 60/40 portfolio is that no one really knows where it came from. While this is a popular benchmark, Mueller-Glissmann points out that it wouldn’t be for everyone. Someone close to retirement might want a larger proportion of their savings in bonds, for example, while someone investing early in their career would probably want to buy more stocks.
The 60/40 may still make sense as a starting point for asset allocation. This is the optimal ratio on average since 1900 for maximizing the risk/reward ratio of a portfolio consisting solely of stocks and bonds (although the optimal allocation to stocks has varied considerably over time depending on the broader macroeconomic conditions), Goldman Sachs Research shows.
The outlook for the 60/40, however, may not improve immediately as inflation percolates and central bank tightening weighs on growth. “I don’t think it’s dead, because the current environment won’t last forever, but it’s certainly ill-suited for that kind of context,” Mueller-Glissmann says. “In an environment where you have both growth and inflation risks, such as stagflation, 60/40 portfolios are vulnerable and, to some extent, incomplete. You want to diversify more broadly into asset classes that can do better in this environment.
Real assets could be more important in a cycle where inflation is higher than what the world has been accustomed to over the past two or three decades. Things like residential real estate can generate profits that outpace inflation. Precious metals and even fine art and classic cars can help protect purchasing power when consumer and commodity prices rise rapidly.
A portfolio with a slice of real assets, such as gold and real estate, performed even better than the 60/40 over the long term. In this case, the optimal strategic asset allocation since World War II was closer to one-third stocks, one-third bonds, and one-third real assets, says Mueller-Glissmann.
“I think that’s a better starting point than 60/40, with everything we know right now, with potentially higher structural inflationary pressures due to decarbonization, deglobalization, and the struggle against income inequality,” says Mueller-Glissmann. He points out that there are also stocks that can have the characteristics of real assets, such as companies that have pricing power and the ability to grow cash flow at a rate faster than inflation.
Investors can also consider assets that fight inflation. “Automation is an example, if you find business models that benefit from structural growth due to higher inflation,” he said. “There are a lot of opportunities that arise because of this new world where we have more inflation and more uncertainty about inflation. But most importantly, they are very different from what we considered to be the best investment of the last 20 to 30 years.
Investors have understood this change. Instead of a tech startup that might not turn a profit for many years, investors favor companies that can already turn a profit and dividend. Warehouses have been a popular investment as e-commerce accelerates. Demand for companies that manufacture storage batteries has increased amid an increasing focus on renewable energy infrastructure.
But as recession risks increase, some real assets have also become more volatile in recent months. Nobel Prize-winning economist Harry Markowitz is credited with saying that diversification is the only free lunch in finance. Mueller-Glissmann asserts that this principle also applies to investing in real estate assets. They tend to be heterogeneous, with different risks.
Real estate investment trusts (REITs), for example, tend to follow inflation over the long term, but they are highly leveraged and perform poorly during a recession. An infrastructure, such as a company that operates an airport or a sewer system, may have regular cash flows from government contracts. But there is always a risk that the company will be hit by new tax burdens or regulations. And while commodities like oil and grain are essential basic needs, their prices tend to be extremely volatile when there are imbalances between supply and demand.
“You also want to have a bit of real-asset diversification,” says Mueller-Glissmann. Goldman Sachs Research crunched the numbers and found that roughly equal weighting (about 25% each) between real estate, infrastructure, gold, and a broad commodity index led to the best time-adjusted performance. risk in times of high inflation. Allocations to Treasury Inflation-Protected Securities (TIPS), which were created in the late 1990s and are a more defensive real asset, can help reduce cyclical risk while providing inflation protection.
Going forward, active portfolio management, allocations to alternative assets – such as private equity, but which may also include hedge funds – and new risk mitigation strategies, such as options hedging, will be more prominent in multi-asset investing, Mueller-Glissmann said. .
“I wouldn’t agree that diversification is the only free lunch in finance,” he added. “But it certainly remains a fundamental investment principle for any investor.”