The Old Guard: Traditional Portfolio Composition
For decades, the blueprint for investment portfolios created by many financial advisors and stockbrokers was a straightforward 60% allocation to stocks and 40% to bonds or other fixed-income instruments. This mix, referred to as a balanced portfolio, performed admirably through the economic swings of the 80s and 90s.
However, the investment landscape has shifted dramatically since the turn of the millennium. Persistent bear markets and historically low interest rates have chipped away at the efficacy and appeal of this simplified investment strategy. Today's experts suggest a need to incorporate a more diverse range of asset classes for an investment portfolio that's truly robust, designed to sustain long-term growth in a changing economic environment.
The Changing Face of Investment Strategies
Bob Rice, Chief Investment Strategist at Tangent Capital, offered an insightful perspective at the fifth annual Investment News conference for alternative investments. He projected a mere 2.2% yearly growth rate for the 60/40 portfolio and encouraged investors seeking substantial diversification to consider asset classes beyond stocks and bonds. His list included private equity, venture capital, hedge funds, timber, collectibles, and precious metals.
Several factors contribute to the declining performance of the traditional 60/40 mix. These include high equity valuations, untested monetary policies, increased bond fund risks, and underwhelming commodity prices. An explosion in digital technology has further reshaped industries and economies, significantly influencing growth trajectories.
Rice's investment mantra: "Invest in multiple futures." According to him, the drivers behind the success of 60/40 portfolios are no longer effective. He argued that stocks and bonds alone can't meet investors' needs for income, growth, inflation protection, and downside protection.
As an example, Rice referenced the endowment fund of Yale University, which currently has a mere 11% allocation to traditional stocks and bonds, with the remaining 89% invested in alternative sectors and asset classes. Though one portfolio's allocation can't be used to predict broad trends, the significance of this being the fund's lowest ever allocation to stocks and bonds cannot be ignored.
Rice suggested that advisors consider alternative asset classes in place of bonds, such as master limited partnerships, royalties, emerging market debt instruments, and long/short debt and equity funds. Advisors can employ mutual funds or ETFs to integrate these assets into small and mid-sized client portfolios, ensuring compliance and effective risk management. With the growing number of instruments available for diversification in these areas, implementing this approach is becoming feasible for clients of all sizes.
The New Wave: Diversification beyond the 60/40 Mix
Alex Shahidi, a teaching professor at California Lutheran University and Managing Director of Investments at Merrill Lynch, critiqued the 60/40 mix's performance in fluctuating economic climates in a 2012 paper. Using historical return data dating back to 1926, Shahidi argued that a portfolio with a 60/40 mix was as risky as an all-equity portfolio.
Shahidi proposed an alternative portfolio consisting of roughly 30% Treasury bonds, 30% Treasury inflation-protected securities (TIPS), 20% equities, and 20% commodities. He demonstrated that this portfolio could match the returns of the traditional 60/40 mix over time, but with less volatility. This is because TIPS and commodities generally excel in inflationary periods. Also, at least two of the four classes in his portfolio perform well in each of the four economic cycles—expansion, peak, contraction, and trough—thereby delivering competitive returns with substantially lower volatility.
The traditional 60/40 portfolio mix, while effective in the past, has come under scrutiny in recent years due to changing market dynamics. Experts like Rice and Shahidi advocate for a broader approach that incorporates a wider range of asset classes. They suggest that diversifying beyond the traditional mix can lead to competitive returns with less volatility, better preparing investors for the evolving economic landscape.