So why consider diversifying?
Given that (1) investors have benefitted from a market environment that reliably produced a source of positive returns from a 60/40 mix, and (2) we’ve just completed the best period for that mix in nearly 70 years of tracking, why would an investor want to consider a change?
More specifically, why would an investor consider diversifying a traditional 60/40 portfolio with additional asset classes when the familiar construction has served them so well?
The reason is that the phenomenon of low correlation of returns between stocks and bonds is not a financial law set in stone. Consider the following chart:
- Roughly speaking, the second half of the timeline shows low and typically negative correlations between returns of stocks and bonds. That’s what investors have now become accustomed to.
- By contrast, the first half of the timeline—which begins in the late 1970s—shows much higher correlations. During that period, on average, the outcomes of stocks and bonds were, for better or worse, more closely aligned.
Why complements now?
No one can reliably predict where economic indicators or the markets will go with precision, but we can observe the information at hand to make informed judgments. First, it appears highly likely that interest rate hikes are coming for the foreseeable future, which may continue to weigh on bonds. Next, on the equity side, the impact of higher debt costs, rising input costs (inflation), and geopolitical turmoil are unlikely to serve as tailwinds to the stock market. The combined effect of these issues poses challenges for the traditional 60/40 portfolio.
We believe the inclusion of complementary asset classes may help portfolios weather any market storms to come. Not because these asset classes are free from difficulties themselves, but because they expand the opportunity set of return generation and reduce the reliance on any single part of a portfolio.
This occurred during the first quarter, when several asset classes we define as complementary strategies were resilient in the face of challenges to stocks and bonds:
- Private debt investments gained 3.0-3.5%
- Commodities gained 25-33%
- Infrastructure investments gained 3.7%
- Global macro strategies gained 5.4%
This isn't meant to suggest that complementary asset classes are superior to stocks and bonds; they're no better or worse in an absolute sense but may be better or worse in certain environments. The market environment of the past was tremendous for a 60/40 portfolio. Still, the environment appears to have changed, and the best-suited portfolio from the past may not be best suited for future periods. When evaluating the benefits and risks of complementary asset classes, we encourage each client to discuss their particular situation and tolerance for risk with their advisor.
While I can confidently say that better weather will arrive in Wisconsin, bringing pleasant, sunny days, I can't know precisely when that will be, so I'll prepare by bringing my jacket and hat to be ready. We believe positioning investment portfolios for uncertain outcomes is an equally wise approach.