In the last Charts & Parts post we talked about “Higher for Longer”, and now we will take a closer look at the 60/40 (stock/bond) portfolio, as well as offer up an alternative solution. The 60/40 is a popular allocation and part of our investment zeitgeist. As traditional asset managers have started to pull back from the 60/40 framework (see snapshot below of a simple google search of “60 / 40 investment portfolio”), rebuilding an investment portfolio has become the focus of financial advisors today.
Christopher Cole is one of the sharpest minds on volatility and he has a view on the popularity of this allocation with the quote,
“The entire global financial system is leveraged to the theory that stocks and bonds are always anti-correlated.”
THE EFFICIENT FRONTIER
We will give you the benefit of the doubt and assume your 60/40 portfolio rests on the efficient market frontier. That’s the good news. The challenge – with just two asset classes in the portfolio, you are out there on the risk curve. And with our favored call of “Higher for Longer” – do not be surprised to experience some market induced indigestion.
LET’S CALL IT WHAT IT IS
All the textbooks, pundits, and practitioners emphasize the importance of diversification. Yes, you can own some financial stocks, some energy, and health care. You can also diversify with some small-caps, large caps, and international stocks. But the chances are good – if we see (another) 50% correction in the stock markets, you’re gonna get beat…badly. The bottom line – 60% of anything is hardly diversified. This is not a bad thing. Holding 90% stocks is not a bad thing. Actually, you probably deserve a hat-tip for crushing it with a 90% allocation to stocks over the years.
But the important thing is to recognize the risk and call it what it is – YOU ARE A SPECULATOR.
Again, this is fine, as we believe in speculating. Speculation is where a lot of money can be made. The challenge – speculators operate under a different set of rules: mainly, working with stops.
STOP LOSSES
We have all heard it a thousand times – cut your losses short. It is the number one rule of trading. And rule number two is to not forget about rule number one. The problem – most know this, yet very few execute on this. I spent thirty years in the derivatives business, and I can name literally just ONE customer that executed stop losses…well. The speculator is most likely not around for that 50% correction, but if they are – you can bet they have a strong view.
When the market is down 50% the speculator will either be exiting with their stops or adding with their conviction. The speculator will not be frozen, staring at their screen.
THE MULTI-ASSET SOLUTION
A potential solution is a multi-asset allocation: adding more assets into the mix to improve one’s Sharpe ratio through diversification. Especially now, with all the access to various markets around the world, we can achieve better diversification. Assume we have a 20% allocation across five different asset classes: we now have five levers to pull vs. just two in the 60/40 portfolio.
This will also reduce the odds of making a big mistake. The first rule to making money is to not lose. With a 60/40 portfolio, one stands the chance of making a big bad expensive mistake. If, for example, you decide to cut your stock exposure in half, that is a 30% bite (portfolio adjustment), at potentially the wrong time. The multi-asset approach reduces the odds of this happening.
Disclaimer: The information contained in this article is for informational purposes only and should not be considered as investment advice. The information presented in this article should not be interpreted as a recommendation to buy, sell or hold any security or investment. Before making any investment decisions, it is important to do your own research and seek advice from a qualified professional. Investing in securities and other financial instruments carries a high level of risk and may not be suitable for all investors.
