What happened?
Investors have long been told that the ideal portfolio should carry 60% of its holdings in equities and 40% in bonds. That is a mix that provides greater exposure to historically superior stock returns. At the same time, it also grants the diversification benefits and lower risk of fixed-income investments. However, in a recent publication by the Bank of America, portfolio strategists Derek Harris and Jared Woodard have argued that the 60/40 portfolio needs rethinking.
They argue that there are good reasons as to why the 60/40 portfolio will most likely not outperform portfolios with more proportion of stocks versus bonds in it. Hence, it makes sense to allocate a greater share of equities to your portfolio instead of bonds. According to the authors, “The relationship between asset classes has changed so much that many investors now buy equities not for future growth but for current income, and buy bonds to participate in price rallies”. This is a completely reverse relationship compared to that which used to be present in markets. The rationale used to be investing in equities for price rallies, and buying bonds for current income.
Why is this important?
In general
Investors have long thought that long term, the 60% stock, and 40% bond portfolio was the golden rule. It gives you the upside of equities, while also protecting from downturns, having bonds in your portfolio. However, there are good arguments as to why this ratio should be more in favor of equities. This changes the whole investment and portfolio management dynamic for investors.
For investors
So, what are some of the reasons why investors should look into switching from bonds more to equities? As it turns out, in 2019 there were $339 billion in inflows to bond funds globally. However, there also were $208 billion in outflows from global equity funds. The graph below depicts this ongoing trend.
Source: Bank of America Research, Marketwatch
This has caused bond yields to fall enough that there are now 1,100 global stocks that are paying dividends above the average yield of global government bonds. As depicted in the chart below.
Source: Bank of America Research
The chart depicts global bond yields (horizontal axis) vs dividend yields (vertical axis). Based on that, there are a whopping 1100 stocks within the MSCI ACWI index that pay more in dividend yield than the average yield of global government bonds. The global economy slows due to the aging population in the developed world. This helped fuel the rally in bonds in many countries. In many respects, the bond rally is a bubble. This threatens to derail returns for investors who maintain a typical 60-40 split.
According to the authors, “The challenge for investors today is that both of those benefits from bonds, diversification and risk reduction, seem to be weakening, and this is happening at a time when positioning in many fixed-income sectors is incredibly crowded, making bonds more vulnerable to sharp, sudden selloffs when active managers rebalance”.
As they continued to add, “The core premise of every 60/40 portfolio is that bonds can hedge against risks to growth and equities can hedge against inflation; their returns are negatively correlated.” But this assumption was only true over the past two decades and was mostly false over the prior 65 years. The big risk is that the correlation could flip, and now the longest period of negative correlation in history is coming to an end as policymakers jolt markets with attempts to boost growth.”
Source: Bank of America Research
The chart above depicts this very idea. That is, bonds and stocks have only correlated negatively in the past 20 years. However, their average correlation throughout the prior 65 years was actually positive. If this were to flip, this would have significant implications for portfolio creation for investors.
For traders
While this does not concern traders as much as it does investors, there some additional things we can all learn from this. That is, the latter arguments for more equity exposure fit nicely with the demographics currently in place in the US. You can read more about the US demographics and how they might drive stock prices in the future here.
