The success of the simple 60/40 portfolio has been one of the defining features of the investment landscape over the past decade. A combination of persistently declining bond yields and exceptional performance from US equities has meant that it has trounced most alternative allocation approaches. Doing anything but hold a 60/40 portfolio (or a derivation of it) has almost inevitably come at a cost. It is now considered to be the natural, default option by many investors. It is not clear, however, whether this status is because of something innate in the 60/40 structure that makes it the neutral choice, or whether investor opinions would change if it endured a prolonged spell of disappointing returns.
This piece is not another critique of the 60/40 approach (most of which are attempting to sell another product), nor an assertion that investors must do something else (aside from lower their expectations for future returns). It is about how investors treat evidence. What evidence we choose to use, what we choose to discard and the importance we place on certain elements.
A ‘passive’ allocation to a 60/40-type portfolio is often framed as the obvious, evidence-based investment decision, and there is certainly compelling support for it. The returns have been stellar, particularly since the secular decline in yields began, and it has inevitably been boosted by the low costs typically attached to this approach to investment. Yet in assuming this is now the only approach to adopt in the future, we are inescapably ignoring other pieces of evidence.
Investors in 60/40 portfolios hold significant allocations to the US equity market (which has been a particular boon for non-US investors) and long duration sovereign / quasi-sovereign bonds. Holding a US equity focus in a portfolio now is to choose to ignore the evidence that over the long-run expensive markets tend to produce lower returns than those which are more attractively valued. Furthermore, owning long duration, low yield assets is a recipe for higher volatility and underwhelming returns.
If we suspend our disbelief and imagine that over the next ten years US equities have been trounced by other developed and emerging markets, what would our reaction be? Would the 60/40 still be the in-vogue, evidence-based default, or would something else now be in its place? Given how sensitive our investment perspectives and purported beliefs are to historic performance, it is almost certain that investment industry would be awash with obituaries for a 60/40 approach, probably at the precise time it becomes a more compelling option.
When an investment strategy has been successful, particularly for a sustained period, it is incredibly difficult to envisage this changing. Yet we only have to look at the performance of the value factor over the last ten-years (plus) to understand how this can occur. Having exposure to value is well-supported by the evidence but has failed to deliver meaningfully for a sustained period. Even investment approaches that work will go through arduous period when they don’t. No strategy is immune to this.
In the scenario where a 60/40 portfolio has struggled relative to other options, investors have endured a cost because they have focused on a certain piece of evidence (the long run success of this approach) and ignored other relevant information (the long run poor results of expensive assets). This is perfectly reasonable. All investors are faced with a plethora of evidence, and it is upon us to filter this and focus on that which we believe to be most robust and material.
The danger is to assume that any view we take is neutral. It is not. We are always making judgements and trade-offs. It is easy now to state that a 60/40 approach is simply following the evidence because it has performed so well, for so long. Yet we frame and weigh evidence through the window of recency. If something is working now, then the evidence we have supporting it seems more important and more obvious. It is easy to disregard or underweight evidence to the contrary.
We can see how past performance informs our use of evidence by looking at the typical home equity bias held by investors. From an investment philosophy standpoint there is limited compelling evidence for holding a heavy bias towards our domestic market, but how any given investor perceives the home bias is likely to be dictated by where they are located. In the UK, there is an ongoing clamour to remove this home skew. Not because everyone has suddenly alighted upon the evidence, but because returns from the UK equity market have been wretched (on a relative basis) for years. By contrast, is it unlikely that US investors are desperate to increase their exposure to underperforming international markets.
If anything, in this scenario, it is UK investors that should be more circumspect about the speed of such a shift in allocation given the evidence of strong long-run performance from undervalued markets, but this is far from the case. Recent performance is not only used as the most important piece of evidence, but it also frames how we perceive all other information.
Our time horizons are also a major defining factor in the evidence we choose to follow and that which we choose to ignore. Investment approaches supported by the most robust evidence only play out over of the long-run (if at all) and patience is required to see it come to fruition. One thing the investment industry has little of is patience. That is why the evidence of what is performing well right now is so compelling. We are not asking people to wait, to believe something different to what they are currently witnessing or bear uncomfortable risks.
Even if we consider something to be the neutral investment option it is imperative to consider the evidence we are using to support that view and also justify why we have chosen to ignore other pieces of evidence. We also need to envisage a future where the default disappoints and understand how we would react in such a scenario. The 60/40 has been a great option for many investors, but we cannot forget that it is an investment view and should treat it as such.