A look at what market changes did to the traditional allocation
The following is excerpted from a longer discussion of this topic on the Your Thriving Practice podcast with Matt Estes, a managing director and senior product strategist for the Global Allocation Portfolio at BlackRock, and Charles Rotblut, vice president of the American Association of Individual Investors and editor of the AAII Journal. You can listen to the episode here.
What happened in 2022?
Matt: Historically, bonds have worked as an effective hedge when the risk to the market was some sort of economic contraction. Bonds don’t serve as well when the risk to the market is an overly aggressive Fed. Markets can only focus on one sort of risk at a time. This time around, bonds didn’t provide that traditional hedging characteristic, and that was largely predicated on the view that inflation was a lot higher than most had expected and the Fed was really aggressive in trying to tamp it down.
Was this a blip or something permanent?
Matt: Calendar year 2022 was fairly unusual. We went through a very rapid rate hiking cycle. That’s not an environment we’re likely to experience again over the next few years. Bottom line, I think bonds are now getting closer to their traditional role every day.
"the optimal strategy is always the one you can stick with no matter what the market’s doing."
And remember that the last time we saw that dislocation between stocks and bonds, where they both moved in the same direction, was almost 50 years ago. I don’t think history repeats itself in the short to intermediate term. 60/40 is still a viable allocation for many clients.
Charles: It was a blip. It doesn’t mean we won’t see another blip in the future. History won’t necessarily repeat itself, but obviously there are scenarios where you could see something happening involving war, a pandemic, commodity shortages, storms that could cause a spike in inflation. But having all these events happen at once is an unusual set of factors. It wasn’t a sea change.
Why should portfolios be more flexible and nimble?
Matt: The environment in which you could take a “set it and forget it” approach to a portfolio is largely behind us. The period of central banks coming to the rescue isn’t taking place anymore. We’re not in an environment where inflation is sitting at 1.7%. Supply chains are being redrawn, and we’re facing more elevated levels of geopolitical risk. All these things warrant portfolios that can change the composition of what they’re holding and react to different market and economic conditions.
What should investors be thinking—and doing—in both the short term and the long term?
Charles: It really comes down to when do you need to pull cash out your portfolio. If you’re thinking it’s really about capital preservation, not exposing the money you need to withdraw to market volatility, it’s clearly short term. But if it’s long term, then you need to think about capital appreciation. In that case, your big risk is inflation and you need your savings to grow faster than the rate of inflation over the long term. And if you have a big goal like retirement, it’s not just a matter of preserving your purchasing power, but also growing it in absolute terms.
Matt: It’s important to have a longer-term strategic view and then on the margin be a little more tactical to adjust to different market conditions. But it’s really less about timing the market and more about time in the market. If you can embrace strategies that are less volatile and you can smooth out the ride, you can try to overcome some of that psychological investor behavior where clients or investors want to capitulate at the market bottom.
Charles: Yes, the optimal strategy is always the one you can stick with no matter what the market’s doing. For some people that’s full equities, but others really need to tone down the volatility. For a lot of individuals, the biggest risk is behavioral: I don’t like headlines, so I’m going to pull out of the market and wait for things to get better. When they do that, they miss the big rebound.
How should financial professionals discuss these issues with their clients?
Charles: First, I’d just sit them down and start talking with them about their goals, asking them why money is important, what they’re saving for. I’d get them to envision what they want to do with the money. And hopefully, that calms them down. But if you have a client who’s really nervous and really wants to do something, try to create a window within their portfolio where they can move around a bit, something a bit more conservative with less volatility.
Matt: It’s managing investor expectations and keeping them emotionally on track. If their risk tolerance or their end financial goals haven’t changed radically, then stay the course, follow the plan that you put in place. You try not to let one outlier year, one exogenous event completely disrupt the plan.
Charles: If you can, get your client out of the office, maybe meet them for coffee or go for a walk, move into an environment where it’s not all about financing. That allows them to calm down a bit. It gives them that little mental break that can sometimes do wonders.
What does the possibility of an impending recession mean for following this strategy?
Charles: If we do have a recession, you would tend to see a flight to quality, to more stable companies, toward more investment grade bonds. But remember that predicting the timing of recessions is very hard. The market has gotten it wrong several times. The Fed does not have a very good track record of achieving soft landings.
"History won’t necessarily repeat itself, but obviously there are scenarios where you could see something happening"
But if people have their portfolios properly allocated and they do have some assets that might hold up well in a recession such as a blue chip dividend paying stocks, they should be able to ride it through since recessions are a normal part of the economy.
Matt: Historically, in recessions, higher quality bonds have done a good job of providing a bit more ballast and a bit more of a hedge. On the equity side, I would be a little reluctant to hold a lot of cyclicality in the portfolio. I’d want to maintain more of a defensive posture in that component of the equity allocation.
Where do we go from here?
Matt: There was a period of time recently where people believed that the 60/40 portfolios were more or less dead because the 40% of the portfolio wasn’t really providing any meaningful income. I think, though, that we’re getting closer to bonds serving as that more efficient hedge again, and you’re generating a much more attractive level of carry, whether it’s in areas like credit or even thinking about some pockets of emerging market debt. I still think that a 60/40 portfolio can be a viable strategy for a broad range of clients based on their own individual goals and suitability. But we’re in an environment where financial market volatility is likely to be higher. So you need the ability to incorporate strategies within your 60/40 portfolio, incorporating things like alternatives. Vanilla stocks and bonds that worked so well over the past 10 to 15 years aren’t necessarily going to be the playbook for a go-forward environment.
Charles: By and large 60/40 has been a very simple but a very good strategy. But you don’t have to be just two simple asset classes: long-term bonds and large cap stocks. You could diversify on both sides. Too often people view asset allocation strategies based on their short-term performance without realizing that they’re supposed to work—and be measured—over the long term. If you’re following a tactical strategy, at any given year, any given month it can be really terrible. But over the long term, you start to see long-term investing as a marathon, not a sprint. Some miles are going to be really tough, and others will go by pretty quickly.