IS THE 60-40 PORTFOLIO DEAD?
Mark Lister, 17 March 2021
There has been a lot of conjecture about the traditional 60/40 portfolio, and whether it is still fit for purpose.
This refers to the typical investment portfolio that many financial advisers recommend to their middle of the road clients. For decades, a good starting point to balance risk and return has been 60 per cent shares, and 40 per cent bonds (or fixed income).
With interest rates having hit rock bottom in recent months, prospective returns from the latter look mediocre, causing some to question whether this long-held approach still has any relevance.
However, many people seem to conveniently gloss over one crucial fact - it’s not just bonds that look expensive.
The crux of the current argument is that bond prices have been pushed up so high (and yields fallen so low) that from here on, returns will be very low and prices are at risk of going down.
In short, low risk assets have become high risk because of extreme valuations, abnormally low interest rates and unsustainable central bank policies.
That all makes sense, but hang on, hasn’t everything else been bid up in value for those very same reasons?
Houses are eye-wateringly expensive, many sharemarkets are at record highs, while other investments such as commercial property, art and classic cars have also powered ahead.
One of the biggest drivers of future returns is the initial starting point of an investment, and today that starting point is higher across the board.
If we’re about to give up on bonds because returns will be lower than we’ve seen historically, couldn’t we say the same for just about every other asset class?
JPMorgan Asset Management, the wealth arm of one of the biggest banks in the world, is forecasting an annual return of 5.1 per cent from world shares over the next 10-15 years.
Forecasts always turn out to be wrong, but this would be less than half of the 10.6 per cent annual return that the S&P 500 in the US has delivered since World War 2.
Closer to home, NZ shares are offering an aggregate gross dividend yield of 3.1 per cent at present, well below the 6.5 per cent yield that prevailed five years ago.
Dividends have historically accounted for a reasonable proportion of returns from local shares, so a lower prospective yield implies a more modest return profile over the next few years.
By giving up on fixed income and bonds entirely, all we might end up doing is reducing one expensive asset in favour of other equally pricey replacements.
I also think we all need to make the distinction between the short-term and the long-term.
Bonds are likely to face ongoing headwinds over the next couple of years, so yes, investors should tilt portfolios toward shares and other growth options to position for this.
However, that’s more of a tactical move, rather than a complete rewriting of the portfolio management handbook.
In two, three or five years’ time, we could be looking at a completely different picture. The economic backdrop will have changed, interest rates could be higher, and the outlook for different asset classes might look the opposite of how it does today.
It would be naïve to believe that bonds will never again offer an attractive risk and return opportunity for investors, just because they don’t today.
A mixture of fixed income, listed property, domestic and international shares still makes the most sense. A dose of private equity can also add some spice, for those who are able and where liquidity needs are not an issue.
Current market conditions certainly suggest tilting portfolios in favour of shares and other growth assets over fixed income, but not giving up completely on the latter.