Of all of the many clever things Mark Twain is alleged to have said, one of my favorites, especially these days, is: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
In the turmoil that is 2020, many market “truths” have morphed into myths. And many trusted investment adages no longer make sense.
One that continues to puzzle me is how many financial advisers still recommend the 60/40 portfolio balance between equities and bonds. Equities will give you growth, the theory goes. And bonds will give you income as well as provide a buffer in times of equity decline. If you want to preserve capital into your old age, we’re told, this is the diversification strategy for you.
That doesn’t hold any more.
Diversification itself is not on trial here. Whether you subscribe to chaos theory or just enjoy a balanced diet, diversification is a pretty good rule of thumb when it comes to a healthy lifestyle (except perhaps when it comes to marriage).
The idea is that diversification spreads risk. What hurts one asset might benefit another, or at least not hurt it quite so much. An asset could have unique value drivers that set its performance apart. And a position in low-risk, highly liquid products allows investors to cover contingencies and to take advantage of other investment opportunities when they arise.
All that still largely holds. What needs to be questioned are the assumptions that diversification should be spread between equities and bonds.
One of the main reasons for the equity/bonds allocation split is the need to hedge. Traditionally, equities and bonds move inversely. In an economic slump, central banks would lower interest rates to reanimate the economy. This would push up bond prices, which would partially offset the slump in equities, delivering a performance superior to that of an unbalanced fund.
Since the crisis of 2008, that relationship has broken down. In fact, as the chart below shows, equities (represented by the S&P 500) have outperformed balanced funds (represented by the Vanguard Balanced Index) in terms of rolling annual performance over the past 20 years.
Why? First, central banks no longer have interest rates in their recession-fighting toolbox. While negative rates are possible, they are unlikely to reanimate the economy enough to turn around a stock market falling on recession expectations.
And, as we have seen this year, the stock market can keep rising even in an economic slump. Driven by lower interest rates and a flood of new money chasing assets, equity valuations became untethered from expected earnings a while ago.
So, there’s no reason to expect equities to have a pronounced down year, and no reason to expect bonds to rise when they do, as long as central banks…
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