Bruce Helmer and Peg Webb
Asset allocation is the process of dividing your investment dollars among various asset categories, typically stocks, bonds, and cash.
Generally, the more tolerant you are of risk, the more you may be able to invest in stocks. Risk-averse investors, on the other hand, may want to invest a larger portion of their portfolio in conservative investments, such as high-grade bonds or cash.
Your time horizon will also help you determine your risk tolerance and asset allocation. If you’re a young investor, you might choose an allocation with a high concentration of stocks because you may be able to ride out short-term swings in the value of your portfolio.
But if retirement is less than 10 years away, your allocation might lean more toward bonds and cash investments.
Limitations of a traditional 60/40 portfolio
The traditional “balanced” portfolio of 60% stocks (intended to provide growth potential) and 40% bonds (to generate income and dampen overall portfolio volatility) has been a long-respected “guidepost” for a moderate-risk investor. It’s also a core offering in many retirement plans.
Over the past decade or so, a 60/40 portfolio, supported by stocks marching to new highs and interest rates dropping to new lows, met lots of investors’ return expectations. That’s because, historically, stocks and bonds have a negative correlation, meaning they rarely move in lockstep. When bonds do poorly, so the theory goes, stocks advance — a perfect illustration of the benefits of diversification.
If stocks do better than bonds, a 60/40 portfolio may begin to look more like 70/30 or 80/20 — at which time a sensible investor rebalances by selling appreciated stocks and buying depreciated bonds at a discount.
During the decade between January 2011 and December 2021, a 60/40 portfolio generated an average annual return of about 11% (9% after inflation) — impressively higher than the longer-term average of 6.1%. But in 2022, stocks and bonds fell deeply in the red, and a U.S.-only 60/40 portfolio lost 16.1%, according to Vanguard. Beginning years before this, some analysts and academic researchers, including members of the Investment team at Wealth Enhancement Group, suggested it was time to rethink the 60/40 allocation.
And what our researchers concluded was that what worked in the past may not work in the future. Traditional approaches to diversification tend to focus on broad asset classes (e.g., stocks, bonds, and cash). But they don’t necessarily offer meaningful or “effective” diversification. In our definition, effective diversification considers a particular asset’s underlying source of risk, which may include one or more of the following factors:
• Company risk — the risk that a company could lose money or go bankrupt
• Interest rate risk — the risk that higher borrowing costs could render a company uncompetitive
• Purchasing power risk — the risk that a company cannot maintain economies of scale
• Manager skill risk — the risk that company leaders make poor decisions about how they invest their capital
The other wild card is inflation, which if it lasts could take a big bite out of the purchasing power of your returns (if not returns themselves). During periods of unexpected inflation, stocks and bonds may both lose money, and these effects may be even more magnified in volatile markets.
While no one can reliably predict where the market will go in the near term, the presence of higher-than-average market volatility, such as we’ve experienced over the past several years, means that balanced portfolios are likely to generate uneven returns, and even sometimes negative.
Possible tweaks to consider
We aren’t opposed to the traditional balanced portfolio as a starting point. But we think investors need to take additional steps — using Effective Diversification — to guard against what we see as a looming low-return, potentially high-inflation investment market over the near- to intermediate-term.
Diversifying with non-traditional or alternative assets such as real assets or commodities can be a central element of effective diversification — under the right circumstances and for the right investor. Our investment team has developed strategies to meet the current market environment:
• An Inflation Protection sleeve, which is geared to portfolios that are skewed more heavily to fixed income (that is, those with more than half of invested assets in bonds) and
• A Low Correlation sleeve, which seeks to dampen equity volatility. (Not without risk, this strategy may give up some positive upside during stronger markets, and so it may be appropriate for investors who are more risk averse.)
These strategies may include the use of alternative investments such as commodities, hedge funds, derivatives or real estate. If you decide to invest in these asset classes, you need to evaluate their appropriateness in the context of your individual circumstances, as well as their greater complexity, research intensity, risks, and costs. A good question to ask yourself or your adviser is, “What role does an effectively diversified portfolio, balanced across multiple asset classes, play in helping me pursue my goals?” — in keeping with your time horizon and risk tolerance.
The 60/40 balanced portfolio is really a shorthanded way of identifying your strategic asset allocation. Some investors may be less aggressive and will want to set an allocation that’s less geared to stocks, such as 30% stocks/70% bonds — especially if they are more conservative or approaching retirement. Others with a longer-term horizon and more risk tolerance may be happier with a 70/30 or 80/20 stock/bond allocation — and may include an optional 10% allocation to alternatives (80%/10%/10%).
Investing over the long haul requires patience and discipline. For the vast majority of investors, we believe that sticking to a strategic allocation to the right asset classes and maintaining effective diversification that considers the underlying sources of risk in asset classes are sensible approaches when navigating today’s markets.
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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Bruce Helmer and Peg Webb are financial advisers at Wealth Enhancement Group and co-hosts of “Your Money” on WCCO 830 AM on Sunday mornings. Email Bruce and Peg at yourmoney@wealthenhancement.com. Securities offered through LPL Financial, member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, LLC, a registered investment advisor. Wealth Enhancement Group and Wealth Enhancement Advisory Services are separate entities from LPL Financial.
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