When Everything Loses Value: Case for Modern Asset Allocation
As we mentioned in our 2022 outlook series, rising rates are challenging for many asset classes, particularly bonds. Further, many investors continue to hold significant bond investments to reduce portfolio volatility and “diversify” risk. The classic 60% stock, 40% bond allocation has performed well over the last few decades because interest rates were generally falling, especially in times of crisis as investors bought bonds for safety. Bond returns have seen low or negative correlations to stock returns since the early 2000s. That means that when stock prices fell, bond prices generally rose to stabilize portfolios.
However, this paradigm is beginning to change. Interest rates are low and theoretically cannot go below zero, thus there is little opportunity for rates to continue to fall and drive up bond prices. Further, correlations between stock and bond returns rose dramatically in 2021, meaning that stock and bond returns have been moving in the same direction (positive or negative). In other words, bond prices can’t always be counted on to rise when stock prices fall. So far in 2022, an admittedly short time period, the S&P 500 stock index and U.S. Bond index are down approximately 1.4% and 1.3% respectively. Stocks and bonds are moving in the same direction. For investors with 60/40 portfolios of stocks and bonds, that means their portfolio may be less “diversified” than they intended. So where should investors turn for diversification?
Large institutional investors have been working on this problem for years. They have been diversifying beyond bonds into areas like real assets, commodities, insurance contracts and even digital assets like cryptocurrency and NFTs. The illustrative “modern” portfolio on the chart below shows how a truly well diversified portfolio could be invested. The world of investing has as many investing options as there are ways to spend money (think about it). We cannot limit ourselves to stocks and bonds.
Lets dive into an example of one of these asset classes – Real Assets.
Real Assets consist of investments in agricultural land, real estate and infrastructure like water utilities and cell data towers. Regardless of the economy, people need places to live and work, food to eat, water to drink and yes, even mobile data. From 6/30/1991 through 6/30/2021, the Private Real Assets index generated annualized returns of 9.3% with a standard deviation (volatility) of 3.1%. Contrast that with U.S. Bonds generating annualized returns of 5.7% with a 3.9% standard deviation. Real assets provided marginally higher returns with less volatility than a portfolio of bonds. Additionally, the correlation of real assets to a portfolio with 60% invested in stocks and 40% invested in bonds was 0, i.e. the returns were statistically unrelated. As always, past performance is not a predictor of future results. But, if the goal is to replace bond exposure with investments that provide returns with lower risk (standard deviation) than stocks, history suggests that real assets deserve consideration.
When constructing your portfolio for the next decade, its important to consider the entire universe of options that exist, not just stocks and bonds. If your portfolio is still “60/40,” we would be happy to discuss a more modern, robust asset allocation to accomplish your investing objectives. Click here to schedule a few minutes to discuss. Check out our video on this topic here.
Notes:
1: Correlation Data from FactSet
2: U.S. Bond Index is the Bloomberg Barclays U.S. Aggregate Bond Index
3: Private Real Assets Index from Versus Capital. Real Assets Index is a custom blended index broadly covering the global real assets equity, debt and commodity markets. The blended index is composed of: 26.67% Dow Jones Brookfield Global Infrastructure Composite Index, 10.00% S&P Global LargeMidCap Commodity and Resources Index, 3.33% S&P Global Timber & Forestry Index, 13.33% Dow Jones Commodity Index, 20.00% Dow Jones Brookfield Global Infrastructure Broad Market Corporate Bond Index, 20.00% S&P Global LargeMidCap Commodity and Resources Corporate Bond Index, 6.67% S&P Global Developed Sovereign Inflation-Linked Bond (USD Index).