Re-thinking the stock/bond split
The 60/40 allocation needs some tweaking
To paraphrase Mark Twain, reports of the 60/40 portfolio’s death have been greatly exaggerated.
For 70 years, the allocation of 60% to stocks and 40% to bonds has been a cornerstone of modern portfolio theory, offering an attractive balance of risk and return. In broad strokes, the model’s strength relies on stocks providing better long-term returns than bonds, but bonds providing a margin of safety when stocks do poorly. Yet 2022 put that formula sorely to the test, as a generational shift in inflation drove a sharp central bank reaction. Rising rates sideswiped bonds, whose yields were at secular lows – a terrible starting point for a bout of inflation. Stocks, meanwhile, began last year highly valued as expectations of a post-pandemic rebound drove investor optimism, but then faced the huge headwind of tighter monetary policy. The result: both stocks and bonds took a beating at the same time.
So much for 60/40? Well, not quite. In fact, the landscape for a traditional portfolio mix has vastly improved this year. Bonds have become a more competitive asset class following the massive reset in yields, and stock returns have improved as fears of recession fade and corporate earnings continue to look resilient. Perhaps not surprisingly, the dual rebound has prompted some market strategists to start talking about a revival in the prospects for 60/40, whose risk/return potential they expect to recover as inflation stabilizes.
While we agree that the demise of 60/40 was written prematurely, our view is somewhat more nuanced. We recognize the apparent signs of a return to “normal”; however, we are far from certain that the conditions conducive to a 60/40 portfolio are that simple. Indeed, while 60/40 clearly does not deserve to be banished to the dustbin of asset allocation history, we believe it might benefit from some tweaking – at least when you consider what may lie ahead for stocks and bonds.
Tweaking the 60/40 split
For one thing, there is the stubborn reality of inflation uncertainty. Yes, the past year has been disinflationary, but getting to central banks’ 2% target still looks very challenging. In fact, we may now be nearing the end of the disinflationary trend as year-over-year base effects weaken, and if energy prices rebound and wages reset higher. (Recent settlements with unionized workers around the world suggest they will.) Inflation expectations are once again rising, which presents a headwind for bonds, even though yields today are far more reasonable than they were two years ago.
As a result, we believe bonds might not provide as substantial a cushion to stocks as they historically have in the event of an economic slowdown. We see two reasons for this. First, if inflation remains sticky, central banks might not have the bandwidth to cut rates as much as they normally would in a downturn or recession. Second, the bond yield curve is already much more inverted than normal, in part because the market has over-anticipated a slowdown and ensuing rate cuts. In other words, the market may have already priced a substantial slowdown accompanied by central bank rate cuts, limiting the upside for bonds.
Stickier-than-expected inflation is not good for stocks, either. Equities protect against inflation somewhat better than bonds do because of their correlation with nominal GDP growth (that is, business models capture some of the impact of higher inflation through price increases), but they still tend to deliver subpar returns during bouts of inflation. As well, stock valuations are on the high end of their historical range, suggesting that longer-term return expectations may be above where they should be if inflation endures.
In short, we might find that sticky inflation once again undermines the efficacy of the 60/40 paradigm, and that stocks and bonds – which often counterbalance each other with less than perfectly correlated returns – move down in lockstep.
Enhance diversification, protect against inflation
What’s the solution? One example is a modification of 60/40 that provides exposure to asset classes offering potential inflation protection and enhanced diversification – albeit not without the potential for adding additional or unique risks to the portfolio as well.
For instance, an investor could implement a 50/30/10/10 asset allocation framework:
- Stocks. At 50%, stocks remain the core of the portfolio model. They are given the largest allocation because they have historically provided the best long-term returns.
- Bonds. At 30%, bonds remain a prominent portfolio component, as they provide competitive yields (currently in the 5%+ range) while offering the potential of downside protection and diversification in the event of a recession, even if to a lesser degree than in previous downturns.
- Real assets. A 10% allocation that includes commodities, infrastructure, and real estate. As a class, real assets have historically offered inflation protection and have a low correlation to financial assets like stocks and bonds. They are also well positioned to capture upside from the secular trends of infrastructure rebuilds, reshoring and deglobalization, as well as the transition to renewable energy. While real assets are subject to risks that depend on several factors including the economic cycle, monetary policy, geopolitics, and corporate earnings, a 10% share could add some meaningful growth and diversification without exposing investors to significant volatility.
- Alternative assets. An allocation of 10% to alternatives such as private debt and equity, senior loans, and derivatives may provide advantages that offset some of the risks associated with these asset classes, including, most notably, a lack of liquidity. In particular, these categories offer upside potential and additional diversification in the portfolio mix.
Please note that this is not a recommendation, but a conceptual framework. Each investor must determine their appropriate asset mix based on their circumstances, objectives, and risk tolerance.
As well, this is not to say that the 60/40 portfolio is inappropriate. It still has the advantages of simplicity and longevity, and it remains a solid long-term approach to portfolio construction. However, the events of the past few years have shown that financial and economic conditions can change quickly, and what worked for portfolio construction yesterday will not necessarily work as well today or tomorrow.
With so much in flux, there is room for creativity and flexibility in portfolio construction, especially to enhance risk mitigation and diversification. In today’s uncertain environment, we believe a varied asset allocation framework is an option well worth considering.
David Stonehouse, Senior Vice-President and Head of North American and Specialty Investments, AGF Investments Inc., is a regular contributor to AGF Perspectives.
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