60/40 Portfolio: Constraints Of Convention by Jeffrey Knight, Columbia Threadneedle Investments
- A 60/40 portfolio may appear to be balanced, but when viewed through a risk lens it is clear that the equity allocation comprises a disproportionate amount of the risk.
- By under-emphasizing equity and relying more on fixed-income, risk-balanced (“risk parity”) portfolios may deliver lower volatility — but with lower expected returns than traditional balanced portfolios.
- Market conditions will always change and evolve, and portfolios that adapt will stand a better chance of navigating those changes.
Sometimes it pays to defy conformity. Consider the story from the world of youth sports featured in Malcolm Gladwell’s book David and Goliath: Underdogs, Misfits and the Art of Battling Giants. The story’s protagonist, Vivek Ranadivé, is an MIT-educated software engineer who found himself in the misfit role of head coach for his 12-year-old daughter’s basketball team. By conventional standards, Vivek, having grown up in Mumbai watching only cricket and soccer, was utterly unqualified for this role.
Vivek approached coaching like the engineer he was trained to be. Without any preconceived notions about how the basketball was supposed to be played, Vivek was puzzled by the strategies that he observed on the court. Specifically, he watched every team retreat to their own end after a change of possession, conceding more than half the court for an uncontested advance by the opponents. Vivek decided that his team — made up of Silicon Valley daughters, most of whom had never even played basketball before — would handle things differently. They would play a full-court press. From the opening tip-off to the end of the game, every game, Vivek’s young athletes would eschew convention and defend every inch of the basketball court. The opposing teams were dumfounded. The team would eventually make it all the way to the national youth basketball finals.
The advantage that Vivek’s team brought to bear against the competition, simply put, is that they defied the “constraints of convention.” Everybody knows that basketball teams don’t press all game long. The full court press is saved for special occasions. This cultural fact pattern was so broadly believed and accepted that other coaches apparently failed to even consider a strategy that stood afoul of these conventions. There is no rule against a full-time press. It is not a real constraint. But nobody does it because…well…nobody does it. It is too unconventional. At least for Vivek’s team, relaxing that constraint proved to be very valuable.
These constraints of convention also exist in the investment business. We should be ever on the lookout for them, for in the parlance of an engineer like Vivek, the shadow price of these constraints can be very high indeed. One example is the idea of what constitutes a balanced portfolio. Investors have long believed that a portfolio of 60% stocks and 40% bonds (the 60/40) is balanced. Indeed, the 60/40 portfolio does look diversified and balanced from a capital allocation perspective (i.e., how the money is divided proportionately across a portfolio). However, the 60/40 portfolio is actually very concentrated from a risk allocation perspective (i.e., how volatility is divided proportionately across a portfolio). Because equities have historically been so much more volatile than fixed income, the 60% equity allocation in a traditional balanced portfolio comprises about 90% of the portfolio’s overall volatility. While this concentration in equity risk can be beneficial when equity markets rise, it introduces vulnerability during periods when equity markets decline.
In order to address this equity concentration, risk-balanced portfolios (sometimes called “risk parity” portfolios) emerged and introduced two significant breakthroughs that challenged conventional thinking. First, risk-balanced portfolios determined asset class allocations based upon expected risk contributions rather than capital allocations. In doing so, the risk-balanced portfolio generally under-emphasized equity and placed a higher reliance on fixed-income. This delivered a better balance of risk and better returns per unit of risk. However, the result of a heavy weighting to fixed income meant that these portfolios would potentially deliver lower volatility. In turn, this also meant lower expected returns than traditional balanced portfolios. Thus, crucially, a second breakthrough emerged, the incorporation of a modest amount of leverage into a strategic asset allocation.
De-emphasizing equity was unconventional enough, but incorporating leverage into a strategic asset allocation was something that just wasn’t done. It was easy enough to do, but like Vivek’s full-court press it was a strategic option that just wasn’t considered relevant due to its cultural absence. But leverage changed everything about efficient portfolio design. By relaxing the no-leverage constraint, portfolio design could exploit the greater efficiency of a well-balanced allocation of risks across the portfolio’s components while simultaneously targeting a desired level of overall volatility and potential return. The result should be — and, in practice, has been — better diversified portfolios and more efficient returns.
Ironically, the opportunity to once again recognize, and defy, conventional constraints exists today with the very strategy that I just outlined. That is, a risk-balanced portfolio itself suffers from its own constraint of convention, which makes it vulnerable to the peculiarities of today’s markets. Simply, it is a static strategy.
I raise the question, Does a portfolio design have to be static? Is that a rule? Perhaps we fail to consider a dynamic strategy because that’s just not how it’s done. I’m not talking about an active overlay, either. I am talking about replacing a static policy portfolio with a rules-based policy function, where the policy portfolio — or benchmark — itself changes in a hard-wired and significant way. For example, if bond yields become so low that forward-looking returns become uncompetitive, the policy portfolio should reorient around a less bond-intensive starting point. If stocks are particularly attractive, then the policy portfolio should become more equity intensive. Instead of always being accountable to the same neutral portfolio, why not shift accountability to a starting point defined by current conditions?
Market conditions will always change and evolve. Portfolios that adapt will stand a better chance of navigating those changes. A full-court press against the constraints of convention may well be the key to investment survival.
The views expressed are as of May 26, 2015, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
Past Performance is not a guarantee of future results.
Neither diversification nor asset allocation assure a profit or protect against loss.
In general, equity securities tend to have greater price volatility than debt securities. The market value of securities may fall, fail to rise, or fluctuate, sometimes rapidly and unpredictably. Market risk may affect a single issuer, sector of the economy, industry, or the market as a whole. There are risks associated with fixed-income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. The use of leverage allows for investment exposure in excess of net assets, thereby magnifying volatility of returns and risk of loss.