09 AUGUST 2017 Modern Portfolio Theory (MPT) has become the reigning paradigm for investment management over the past 30 years. Widely used by investment advisors, institutional investors, and sophisticated investors, MPT stresses the benefits of portfolio diversification, notably in the allocation between stocks and bonds. Because these two assets are supposedly uncorrelated, or have a low or negative correlation, a portfolio comprised of 60% stocks and 40% bonds (60/40 portfolio) was felt to be the “optimal” portfolio for investors. The exact mix of stocks and bonds varied depending on the age and risk tolerance of individual investors. Older and more risk averse investors [...]
Older and more risk averse investors received a lower allocation to stocks and larger allocation to bonds. Conversely, younger and more risk-taking investors received a higher allocation to stocks.
MPT and the 60/40 portfolio were developed during the “Great Moderation,” the period between 1980 and 2008. Investors had the wind at their backs during this period, which will be seen as the golden age for investors. Beginning in 1980, inflation and interest rates declined dramatically, setting the stage for unprecedented rallies in BOTH stocks and bonds. A 60/40 portfolio returned an average of 5-6% during the Great Moderation not because stocks and bonds were uncorrelated, as MPT would have it, but because they were both on an upward trajectory.
Additionally, MPT and its adherents maintained that stocks will outperform bonds over a medium-term period of time. Thus, bonds were included in portfolios because of their lack of correlation with stocks, despite their supposedly lower returns. As it turns out, despite expectations of MPT proponents, bonds outperformed stocks during the Great Moderation because of the appreciation in price that resulted from the sharp decline in interest rates. (Bond prices are inversely related to yields; a lower yield results in higher bond prices).
Given the anomaly of the Great Moderation years, it is fair to ask whether a 60/40 portfolio still works in the present-day deflationary environment?
Today’s economic environment has been called the “New Normal,” characterized by a slow rate of economic growth, low interest rates, high level of inequality and low growth in income. It is also on the verge of descending into a deflationary economy, marked by a general decline in the price of goods and services. Deflation, last seen in the U.S. during the Great Depression, already plagues Japan and parts of Europe. Deflation would bring continued low interest rates, economic growth and income growth.
As for stocks and bonds, both markets have experienced massive bull markets and stand to fall over the next few years. Bonds prices have tracked the decline in interest rates down to the zero-level, and don’t have much more room to rise. (i.e., there is a limit to how much further interest rates can decline). Stocks continue to post record highs despite the lack of good news about corporate profits or economic and productivity growth. With price/earnings ratios approaching 25, well above the historical average, it is more likely that stock prices will decline than that they will rise over the medium term.
Under these conditions, it is very possible that the 60/40 portfolio suffers the reverse of its performance during the Great Moderation: i.e., that stocks and bonds will maintain their positive correlation, but this time on the downside.
What can an investor do?
One alternative is to take a more active approach to portfolio management by timing the market. This can take the form of shifting allocation between stocks and bonds; value and momentum; sectors; small cap and large cap, etc. The pitfall here is the overwhelming evidence that market timing is extremely difficult to get right for any sustained period of time.
Another course of action is to reduce a portfolio’s beta sensitivity to the major stock and bond markets. This can be accomplished in a number of ways. One is via alternative investments – either by direct investment in hedge funds or by investing in liquid alternative investments — which take short positions on the major markets, thereby reducing the portfolio’s market exposure. A similar strategy is to invest in absolute return funds. Finally, one can invest in uncorrelated assets such as commodities, real estate and managed futures. An optimal portfolio in the future may well be comprised of only 30% stocks, 30% bonds and 40% in these other investments.
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