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This article first appeared in the Telegraph
JAMES Goldsmith famously quipped that if you see a bandwagon it’s too late. He was right. One of the truisms of investment is that when everyone is talking about something, the moment has passed. That something at the moment may be the death of the 60/40 portfolio.
For those with better things to do than immerse themselves in investment jargon, a quick explainer. 60/40 is shorthand for a balanced portfolio that invests roughly 60% of its assets in shares and 40% in bonds. The reason for the weighting towards shares is that over time that’s where the growth is; the 40% in bonds is enough to offset the volatility of the stock market but not so much that it gets in the way of shares’ long-run outperformance.
That’s the theory. How has it worked? Extremely well for long periods of time, which is why financial advisers have loved it. The performance of a 60/40 portfolio has marginally underperformed a pure equity investment but with something like 40% less volatility. That’s a great combination for an investor. Decent returns and undisturbed sleep.
And how has it achieved this alchemy? Quite simply because most of the time shares and bonds move in opposite directions. If things are going well, shares rise in value and bonds fall. When things get tougher, shares might fall but bonds will go the other way, because interest rates and bond yields tend to fall in recessions. Bond prices rise when bond yields fall.
So why are people now talking about the demise of the 60/40 portfolio? Principally because investors no longer believe that bonds and equities will move in different directions for the foreseeable future. Because shares have risen a long way since the financial crisis, they are now quite highly valued by historic standards. And because bond yields have fallen pretty steadily over the past 40 years or so, they too are expensive versus history.
Add to that today’s high and rising inflation and rising interest rates and a strong argument can be made for both shares and bonds performing less well from here than they have in the past. Crucially, they might both do so at the same time. Their performance will, to revert to the jargon, be correlated.
The whole point of a 60/40 portfolio is that there are swings and roundabouts. One hand gives and the other takes away. But if both assets are underperforming at the same time, there is no advantage in splitting your savings between them.
Actually, the real reason that everyone has loved the 60/40 portfolio in recent years is only partly the insurance against losses provided by the split between bonds and shares. It is more to do with the fact that the extraordinary central bank stimulus of the past 13 or so years since the financial crisis has been great news for both of these assets.
Rock bottom interest rates and massive purchases of government bonds and mortgage-backed securities have provided a tailwind for both shares and bonds. It’s not the lack of correlation that has been attractive but the fact that their performance has been both correlated and delivered positive returns. What’s not to like about that combination?
The conventional wisdom today is that neither shares nor bonds will thrive in a low growth, high inflation environment. And this week’s data on both sides of the Atlantic supports that negative case. The UK economy ground to a halt in February and inflation hit multi-decade highs in both the US and over here. Stagflation is bad news for both bonds and shares.
But what if? What if the conventional wisdom is wrong on both fronts? First, the outlook for shares may be rather more resilient than it seems right now for a few reasons. Valuations have been falling for more than a year now. Shares are cheaper than they were. Corporate earnings are still rising, by perhaps 10% this year and in the next couple of years too. And then consider fund flows. Something like six times as much money has gone into bond and money market funds since the financial crisis than has been invested in shares. Even just some of that money seeking better returns in equities would provide significant support.
As for bonds, the case against rests on the unarguable point that inflation and rising interest rates are a killer for fixed income investments. No-one disputes that. But what if the futures markets are correct in their belief that the Federal Reserve overestimates its ability to raise rates and keep them high. Rate futures are telling us that the Fed will go hard and fast this year but within 18 months or so will be bringing interest rates back down to a neutral level of around 2.5%. This week’s weaker than expected core US inflation, excluding food and energy, points that way.
With 10-year yields already at 2.7%, perhaps the pain will soon be over for fixed income investors. If yields rise any further, say to 3%, an investor is likely to think that’s a pretty attractive entry point, coupled with a more or less guaranteed return of capital from a government with a printing press. And if, inflation falls as fast as it has risen, which could easily happen once the year-on-year comparisons become more favourable, that could even represent a positive real return.
So, I wonder whether the death of the 60/40 portfolio, like Mark Twain’s, has been exaggerated. I can accept the case for broader diversification - maybe 50 shares, 30 bonds, 10 alternatives like commodities and gold, 10 cash. But the underlying principle of putting your eggs in more than one basket is alive and well.
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.
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