Has Traditional Asset Allocation Finally Met its Match?
The implications are significant for those relying on target date funds and so called “allocation” funds to manage risk.
OK, this is a long and detailed post. If you really want to understand how I see the investment climate we face right now, and how I plan to invest in this new environment – feel free to dig in. Comments are always appreciated (I like to know people are reading!)
History of the Diversified Portfolio.
For most of my generation’s working life investing seemed simple. If you bought, held, and maintained a simple portfolio with 60% in a stock index fund and 40% in a bond index fund you did as well or better over time than most professional investors. In fact, many professional investors ended up hitching up to that train. More cautious investors might aim for 50% stocks, 50% bonds – more aggressive investors maybe 70/30 – but the idea is the same. Stocks provided phenomenal growth during our lifetime, filling our portfolios, and allowing many to enjoy well-funded retirements. Just look at how $10,000 invested in stocks in 1984 is worth over $600,000 40 years later (with reinvested dividends). I only hope my kids can enjoy a similar outcome!
Oh, sure, there were glitches. And while a 40-year chart like this makes the ride look like a moonshot, we all know from hard experience that it was anything but! But through each major market failing over the years, having a swath of one’s portfolio in bonds helped soothe the pain. Let’s look at each period alone and see just how well this strategy worked.
1994 to 2004. From 2000-2003 stocks suffered a long, difficult bear market. But during that time, interest rates fell causing bond prices to rise. Furthermore, even though tech and internet stocks famously took a beating during that time, boring old value stocks (“blue chips”) did quite well. In fact, while investors in the “trend du jour” (internet stocks) saw their portfolios get crushed, the 60/40 allocation investor who stuck to well diversified funds and kept some money in bonds actually did ok during the early aughts.
Here is how stocks and bonds performed from 1994 through 2004. Note how effectively bond fund offset the risk of stocks during the 1998 and 2000-2002 stock downturns. Note further the steady and relentless rise in bond funds, as interest payments accumulated and bond prices rose as interest rates were cut to fight off the recession. (The blue line is the Vanguard Total Stock Market Index fund, the green is the Vanguard Total Bond Market Index fund.)
2005 to 2015 Naturally, the financial crisis dominated this period. Again, stocks (of all varieties) got crushed. But not only did the Fed push interest rates to near 0 – but they started buying bonds of all varieties like they were going out of style! Bond prices surged – again cushioning the stock market blow for the 60/40 investor. Here again, note the pattern, as bond funds provided a nice counterbalance to the crushing losses in stocks (this time the bond fund is in red):
2015 thru 2020 The status quo continued relatively uninterrupted and even accelerated through the pandemic scare, even as bond interest rates approaching 0% started to make no sense to rationally minded investors. Bonds performed strongly through the 2018 bear market, and the 2020 pandemic crash.
Beginning of the New Era
By the end of 2020, the 10-year US treasury bond was paying less than 1% in interest. Keep in mind, bond returns come from two sources – a) interest payments and b) increase in price. Prices of most bonds (excluding risky corporate bonds) move in the opposite direction of interest rates. Well at this point, you wouldn’t expect to make much money on interest rates at 1%, and you sure couldn’t bet on rates going down much from there! It would seem that there was little potential upside for bonds. In fact, it seems that there was unlimited downside (rates can rise to infinity!) but very little upside (below 0% you are paying someone else to hold your money!)
Yet investors had been conditioned by 40 years of success to believe that owning a balanced portfolio of stocks and bonds would be sufficient to manage the risk / return tradeoff forever. Heck, it’s done so well for so many years! For almost our entire lives it seemed bonds always went up when stocks went down. And oh – most of the time when stocks went up bonds also went up! But there was a caveat that I always threw out when discussing this synergistic stock / bond relationship – “this won’t work so well if inflation comes back, and interest rates go up…” Until 2021 that warning seemed…well…so SEVENTIES.
But from the end of 2020 through today, this has been the new world investors have found themselves in. The same bond funds which had enjoyed 40 years of tailwind from falling interest rates and low inflation, now faced a stiff headwind as interest rates climbed and inflation became a force again. This was bad news for bondholders – but even worse was the fact that stocks also tend not to like higher interest rates. In 2022 BOTH STOCKS AND BONDS WERE DOWN 15-20%! This had never happened in our lifetime! So suddenly, the two investment classes that had for so long offset each others risk – now were failing in tandem. Note the new CORRELATION (tendency to move in the same direction) of stocks and bonds since January of 2021. (red is bonds, blue is stocks)
Diversification isn’t dead – it’s just become more complicated
The point of this entire post isn’t that diversification is no longer important. It is that diversification has just become a lot more complicated than it used to be. If the future potentially is one that includes higher inflation and higher interest rates (and that is one very possible outcome) – then owning stocks and bonds as your sole asset classes is simply not enough.
Note – diversification is still crucial! Stocks OVER THE LONG RUN will likely continue to provide the best means of keeping ahead of inflation. But for those of us with time horizons of 10-20 years instead of 20-40 years, smoothing the ups and downs of the market, and protection against severe events, remains important. And it is apparent that the 60/40 portfolio isn’t up to the task if the future includes higher inflation and interest rates.
What else can one do? We are using several alternatives.
Cash / Short term bonds. Well, let’s start with boring old cash. You know, money markets, CD’s, short term bonds. (short term bonds are those that are near maturity, so higher interest rates may actually HELP short term bond funds as they can quickly reap the benefits of higher rates. Notice how this short term bond ETF return (in yellow) was flat early in the period when rates were dirt low, then starts to accelerate higher as interest rates soared. This is at the same time that bonds and stocks are falling (for the same reason). For a long time we had written off “cash” as an asset class in its own right, but when rates on money markets are over 5%, and short term investment grade bonds are well higher than that, it is reasonable to allocate a portion of your long term money to cash as an inflation and interest rate hedge.
Annuities. My fee only advisor colleagues love to hate annuities. And I know, they are oversold, include expensive frills that don’t really work as advertised, and can be ridiculously expensive. But they can also offer low risk returns that can beat those of cash investments. At present, it is possible to earn 6% flat interest in one firm’s five-year annuity. Oh, did I mention that those earnings accumulate, tax deferred, for as long as they remain in an annuity? Other annuities offer interest rates linked to market returns that may also be attractive. The key is to work with a fee only advisor who can get you into a “NO-LOAD” (commission free) annuity without long lockup periods or high surrender charges. Trust me - insurance companies will do bad things to customers when they can’t get up and leave!!! Devoting a slice of your portfolio to a carefully selected, low-cost annuity can aid in diversification. Just be really, really careful and always avoid expensive riders or so called “living benefits” or “income guarantees”.
Managed Futures and option strategies. There are other ways to make money when stocks and bonds are both down. Managed futures strategies are strategies which make money by following trends in markets. When stocks are trending up, they can make money following the trend up. When stocks are going down, they can make money on stocks going down. When interest rates are going up or down, same thing. Most of the time, the results are somewhat sleepy. But when a downturn heats up – these strategies can really do well. In 2022, managed futures generally had a great year as both stocks and bonds were in a sustained downtrend. Here are two funds which have been valuable additions to a diversified portfolio over the past few years, compared again to the stock and bond investment debacle of 2021/2022. Note these are different strategies, one much more conservative than the other. (yellow is a managed futures fund, green is an options trading fund)
And Bonds Still Have a Place – but index funds alone don’t cut it.
There is a possible future in which the economy slows, stocks tumble, but the Fed cuts rates aggressively causing bonds to soar. Note that will NOT be good for our cash and short-term allocation – but it would be heaven for longer term bonds (and bond index funds which have a lot of longer dated bonds).
Selecting bond funds is a lot more involved than selecting stocks (where a total stock market fund is about all you may need). Just look at the wide dispersion of results over this nearly 3-year period among the numerous bond funds we use in our managed portfolios. The Vanguard Bond index is dark blue. 5 of the 6 fixed income funds outperformed the index – some of them by a long shot. Will that always be the case? No. Because if interest rates fall dramatically, it is likely that the funds which underperformed during this trailing 3 years, will be the outperformers over the next 3 years.
Past performance tells a story – but doesn’t predict the future (unless the future ends up looking just like the past – which is unlikely). The story here is that bond index funds are much more sensitive to rising or falling interest rates than certain other bond strategies. For the previous 4 decades that was a good thing as rates fell. For the past 3 years it was the thing to avoid. It is important to diversify your bond strategies broadly, since we don’t know what the future may hold.
Investing is suddenly a lot more “hands on”.
It’s a new world out there. There are several possibilities that we face as investors – and it pays to be ready for any of them.
In one future, the economy slows, stocks fall, the Fed cuts rates so bonds rally. In this world, maybe bonds will be an effective diversifier again.
In another future, inflation remains elevated, further deficit spending (on wars, excessive spending, costs of a recession, etc.) forces interest rates still higher, resulting in a repeat of the stagflation years of the seventies. In this future, a portfolio diversified with “all of the above” will probably do a lot better helping investors thrive.
Today’s asset allocation needs to be able to weather many different future scenarios.
The Case for Professional Management in this Dramatically Changed Investment Climate
Prior to the 2020s, self-management seemed easy. Buy a stock index fund and a bond index fund and it was “off to the races”. Stock index funds are still probably the best way to get access to the equity portion of your asset allocation – but it seems everything else has become more complicated. As I point out above – there are many more asset classes with which you can (and probably should) diversify – but each has its own complexities and risks. Understanding all your investment options is more complicated than ever – and it is important never to invest in any product or strategy you do not fully understand! Effectively managing just your bond allocation now may require allocating between several distinct and different strategies. Option strategies and managed futures strategies need to be carefully vetted and monitored. Annuities offer significant opportunities for reducing portfolio risk – but can be a minefield of complexity themselves. In short, it takes a lot more time and experience than most individuals have to build out a truly robust diversification strategy.
I have always considered myself a “buy and hold” investor, with a preference for low cost, passively managed strategies. But investing isn’t religion. Evolving opportunities and risks may call for changes to strategy. It was apparent to me coming out of the pandemic that the same old bond allocation was not going to work as inflation and interest rates turned higher. By shortening maturities and diversifying into some of these other asset classes, I helped my clients weather the nasty 2022 downturn far better than they would have in a static, traditional asset allocation. Changing strategies on a whim, or based on the latest headlines or market movements, or your own “feeling” about the market is still folly, for sure. At the same time, being flexible enough to adapt to a once in a generation tidal change in the economy is just plain common sense. I think the new paradigm is “buy and hold – but be flexible”.
If you have been self-managing your portfolios using simple allocation models – consider that the new world we are in might be getting a whole lot more complex. It may be time to consider having a professional help manage your portfolio. Call me, or set an appointment on my calendar and we can chat about it.
Note: Nothing in here is intended to be interpreted as investment advice, or a recommendation to buy or sell any investment! Asset allocation recommendations and investment illustrations are hypothetical only, designed to illustrate the potential benefits of diversification.