The most generic rule in allocating one’s investments to the various possible asset classes is to be 60% stocks and 40% bonds.
But 60/40 performed very badly last year, after more than a decade of having both bonds and stock rally on the back of low inflation and ever-declining interest rates.
Now there is a debate about whether or not 60/40 is optimal for (at least some) investors. Goldman Sachs believes it is a good choice given that the future is always uncertain. Blackrock wants us to expand into more asset classes. Yet another opinion at Goldman Sachs sees the 60/40 success of the past as potentially gone for a very long time, perhaps even a lost decade.
In episode 11 of At The Rotterdam, Jeff and Rasheed argue that thinking in terms of 60/40 obscures the most important question, which is what portfolio is most suitable for each investor.
This separates the decision into two parts.
What amount of money do I need in the future at various key dates. Or, if no specific needs, how much of my portfolio should be in reasonably safe assets so that I can sleep at night?
For the riskier allocation, what risk premium am I trying to capture and how is the best way to do this? The equity risk premium (ERP) has dominated the past 150 years of investing in the US. But there are others: inflation, credit, liquidity and commodity. There might even be different risk premium in sub-classes (e.g. the smaller company premium in US equities).
The events of 2022 reveal that the bond bucket in 60/40 is far from low risk: Bonds fell almost as much as equities last year. And they were down last year as well!
So fixed income investing shouldn’t simply be a case of owning the bond market. Micro strategies are likely necessary. Institutions call one of these asset-liability matching. Another time we will dig into the best way to do this. For sure, however, a bond fund does not do this.
60/40 is good as a heuristic, reminding us to diversify, and so a good starting point for a discussion. But there are many more dimensions to an asset allocation decision, including one’s own specific needs.