Challenging traditional approaches to portfolio construction

Death and taxes are said to be the only certainties in the world, but for a generation of investors, portfolio construction came close to being a third. The logic was simple but compelling: invest 60% of your portfolio in equities and 40% in bonds. The rationale behind this 60/40 approach to portfolio construction was that equities almost always outperform over the long term, but they can be volatile. By contrast, bonds have tended to be much less volatile and have generally been negatively correlated with equity markets. And while there was some wiggle room for younger investors to be more exposed to equities and older investors to bonds, this approach was considered sensibly diversified, leaving a portfolio well-positioned to weather the ups and downs of stock markets while still generating solid long-term returns.

The problem with 60/40

In recent years – although largely as a result of market trends in 2022 – some established notions of portfolio construction have been challenged and diversification has become less compelling to a new generation of investors. Stocks and bonds have shown an increased propensity to move together, calling into question the balancing effect of the classic 60/40 portfolio. This portfolio challenge played out most notably in 2022 when stock and bond returns were both negative for the calendar year. In 2023, returns were positive for both stocks and bonds, but the correlation remained an issue.

This trend has been further exacerbated over the past couple of years by sustained outperformance in select segments of global financial markets, such as US large cap equities, which has caused portfolios to drift away from target allocations and left many investors with little motivation to look for opportunities elsewhere. However, with a new year comes new forces driving markets, and the winners of the past may not be the winners of the future.

Investing in multiple futures

There are many reasons experts cite for 60/40 portfolio underperformance in recent years, but it is ultimately a range of factors: persistently high inflation, high equity valuations, monetary policies used to tackle Covid, increased risks in bond funds and low prices in the commodities markets. Another factor has been the explosion of digital technology that has substantially impacted the growth and operation of industries and economies. Ultimately, the traditional 60/40 portfolio has been found wanting in an increasingly complex world where two asset classes alone cannot do the job of providing income, growth and downside protection anymore. The turbulence of markets in recent times has led a growing number of researchers and money managers to recommend a broader allocation of assets to achieve long-term growth with a reasonable level of risk.

Hedging against the unknown

While most experts are not prepared to write off the value of the 60/40 portfolio, many have acknowledged the challenges facing traditional methods of diversification. The argument goes that over the past 15 years, stocks have massively outperformed bonds, US equities have trounced international equities, large caps have beaten small caps and growth stocks have done better than their value counterparts. Spruiking the benefits of diversification to clients is increasingly challenging when many investors have benefited, or know somebody who has benefited, from being heavily over allocated to a sector like US tech stocks. But the point of diversification is that it is an effective hedge against the unknown. Five years ago, nobody was talking about a global pandemic, and we now live in a post-Covid world. Two years ago, no one had heard of ChatGPT and AI conversations were largely theoretical. Nobody can predict the next big source of macroeconomic volatility, and it is very difficult to pick the big winners and losers from events that have not yet unfolded.

Reinventing the ‘diversified’ 60/40 portfolio

Whether 60/40 is still a good starting point in portfolio construction may come down to your view on the future path of inflation. Persistent inflation is likely to alter the monetary policy dynamics of the previous two decades. With inflation still above central bank targets in major markets, the concern is that inflation targets will continue to be prioritised over cushioning a short-term downturn in economic growth. As a result, bonds may not offer the same degree of ballast in a 60/40 portfolio. Whatever your view on inflation, now may be a good time to consider alternative strategies that can add diversification and target new sources of return for client portfolios.

The takeaway

For some managers, the conversation has already shifted to the 50/30/20 portfolio, with 50% allocated to equities, 30% to bonds and 20% to alternatives. Alternative investments like real estate solve many of the correlation issues while, for others, private equity is potentially a great return stream. As always, it is about reminding clients that diversified asset allocation for the long term is never about achieving explosive returns. Asset allocation is about smoothing out the investment journey and delivering returns that meet real-world expectations. And there is no time like the present for reshaping portfolios by expanding the diversification toolkit.

Transform your practice with Sharesight

Join thousands of financial professionals using Sharesight to automatically track all their clients’ investments in one place. Spend less time on tedious tasks and more time building valuable relationships with your clients. With Sharesight, you can reduce admin, boost productivity and security, and focus on what really matters — giving advice and growing your business.

Put Sharesight to the test with a free 30-day trial — no billing details required and you can upgrade, downgrade or cancel at any time.

FURTHER READING

• Cybersecurity best practices for financial advisors
• Top 4 challenges advisors face in the Great Wealth Transfer
• Why Sharesight is the best portfolio tracker for financial advisors