Don’t worry. This isn’t a post about how the 60/40 portfolio is “dead”. We talked about how that was nonsense last year and a 60/40 portfolio was up 20% last year right when everyone was declaring it dead. Instead, we’re going to talk about a new framework for thinking about any diversified multi-asset portfolio and where it does and does not make sense.
The 60/40 portfolio cannot and does not “die” because it’s roughly similar to the Global Financial Asset Portfolio (GFAP). The GFAP is presently about 45% stocks and 55% bonds. This is the outstanding market cap value of all stocks and bonds in the world, the two largest financial asset classes by a large margin. This portfolio is what one might refer to as “the efficient market” portfolio because it reflects the total market portfolio. The reason this portfolio cannot “die” is because it reflects the two asset classes that are most widely used to fund corporate investment. So, in order for this portfolio to “die” corporate America has to die. I guess this is possible in some sort of world ending situation, but it’s highly unlikely. Instead, what tends to happen is that corporations fund investment by issuing stocks and bonds and the value of those instruments accrue to asset holders over time as corporations invest and grow. Firms will die within the total market portfolio, but they cannot die in the aggregate. Still, as those returns accrue to asset holders they will be volatile because the economy is unstable at times. But the kicker here is that corporate investment takes a long time to accrue to corporations and shareholders, but if you wait long enough they do accrue to firms in the aggregate.
The reason 60/40 stocks/bonds has a history of working so well is because it’s very close to the total market portfolio except it has an equity tilt to 60% from 45%. Now, taking a Defined Duration approach to this I quantify the global stock market as an 18 year instrument. If you hold it for 18 years the odds of earning about a 5-6% real return are very high. I quantify the bond market as a 5 year instrument. If you hold it for 5 years the odds of you earning a real return of about 2% are very high. And if you combine these assets into a 60/40 you’re taking a higher duration asset and diversifying it with a lower duration asset. This comes out to a 12.2 year instrument on average. People love 60/40 because you can get a lot of the upside volatility of stocks without all of the volatility of stocks because the 40% bond slice is reducing the volatility over time and functionally reducing the uncertainty of the portfolio over a 12 year period (in part because you’re adding a lower return and lower volatility asset).
I love thinking about asset classes across time horizons because it creates clarity about how to best judge instruments. This helps you stay the course when everyone else is panicking about what long-term instruments do in short time horizons. So, when a 60/40 portfolio falls a lot in a year like 2022 and everyone panics about it it’s nice to be able to step back and say “it’s inappropriate to judge a 12 year portfolio over 12 months”. You can dismiss the noise because the hyperbolic short-term response in these narratives makes no sense from an empirically time based perspective. The same thing is true of every talking head making predictions about stocks in the coming 12 months. These people cannot possibly know what an 18 year instrument will do within a 12 month period.
At the same time, people judge things based on a short time horizon for two reasons:
- Life is short and we want to earn as much money as possible in as little time as possible so we can optimize our time here.
- The asset management industry has given us no model for understanding time within a portfolio and actually sells the idea that a diversified portfolio can give you certainty over short time horizons.
In the scope of the Defined Duration model the overwhelming majority of investment funds and strategies fall into two specific buckets: the 5-15 year bucket and the 15+ year bucket.1 A 60/40 fund falls into the 5-15 year bucket. And most stock funds and strategies fall into the 15+ year bucket. These strategies almost always fail to beat a similar market cap weighted portfolio in the long-term because any fund trying to beat the market is just kicking up taxes and fees that reduce their aggregated returns relative to the index.
The problem with a 60/40 portfolio is that it cannot give you near-term certainty since it’s structured as a long-term instrument. This is great for the patient investor and a behavioral mine field for the impatient investor. So you have to be aware of the sequence of return risk that any all stock or multi asset portfolio creates. Investors want two things from their portfolio:
- Short-term certainty
- High returns
The problem is that these two things create a temporal conundrum. It takes time to generate high returns because it takes time for businesses to grow and innovate. So there’s an inherent trade off in the way financial assets work. If you want high returns you need to own long-term assets. And if you want short-term certainty you need to own short-term assets. This is why diversification works. Diversification reduces volatility by reducing time horizons. This is the defining positive characteristic of a 60/40 portfolio. But you need to be aware of what you own because a 60/40 portfolio can go through extended drawdowns at time that will amplify cash flow uncertainty.
The easy solution to this is to know what you own and disaggregate your diversified portfolio as needed. If you need funds for the next 12 months then a bond allocation in the Bond Aggregate makes no sense because that’s a 5 year instrument that could expose you to cash flow uncertainty within 12 months. So, while the Bond Aggregate is great within the context of a longer-term portfolio like 60/40 it is not a sufficient cash flow instrument for anything shorter than 5 years. It could be totally appropriate to tear down the Bond Aggregate so you have a more tangible set of cash flows that are within the 40% component. This might include owning T-Bills or Money Market Funds, but you need to strip those pieces out of the aggregate in order to actually be able to obtain the cash flows and the certainty they give you over the short-term because the diversified 40% component will move like a 5 year instrument even though it might have lots of short-term instruments inside of it.2
In short, 60/40 is a wonderful portfolio for anyone with an intermediate or long-term time horizon of 5-15 years. But if you are expecting that portfolio to provide you with optimal short-term certainty then you are creating an asset/liability mismatch within your own financial plan that could result in significant behavioral risk.
1 – I’ve found that breaking this down into four specific buckets creates a very clear asset allocation approach that covers all potential time horizons an investor might have. This includes the 0-1 year bucket, 2-5 year bucket, 5-15 year bucket and 15+ year bucket.
2 – This could also create the opposite risk for more aggressive investors where the investor feels like they don’t own enough long-term assets at times. This is further reason to disaggregate the stock piece and own another complimentary slice of stocks outside of the 60/40.
Source: Defined Duration Investing