The 60/40 Asset Allocation

Asset Allocation is one of the most important starting points in building a portfolio. Research has shown that, assuming that you invest in a broadly diversified portfolio, a large part of your returns is determined by asset allocation. One of the most well known and basic allocation is the venerable 60/40 allocation.

What is the 60/40 allocation?

In the 60/40 allocation, the portfolio invests into a basket of stocks and bonds. 60% of the portfolio is in stocks and 40% in bonds. But why do we need to split between the 2 asset classes? Why not go all in on stocks (or bonds)? The main objective here is the primacy of risk control and survival, over maximising returns. The way to achieve this is via diversification. An article by the late Peter Bernstein explains this clearly (found HERE) 

Offsetting the strengths and weaknesses of each asset class

The basic idea is simple. Stocks historically provided better returns vs bonds, but are more volatile as markets go through boom-bust cycles. Bonds also had their moments of boom-bust but are less volatile. So having bonds in your portfolio will drag down returns in stock boom years, they serve as an anchor of sorts, to preserve capital in times of volatility.

Hedging unexpected events and not having to predict market direction

The market is a chaotic place and it is hard to time your asset allocation perfectly by moving 100% into stocks before they run up and 100% into bonds before they meltdown. The Lehman crisis was a perfect example. Many astute investors saw the meltdown coming and profited from it, but the majority were caught off guard. After the crisis, many voices predicted years of stagnant returns for stocks and bonds. Yet again, many were caught by surprise when the market went into a bull run.This led to the bull market in stocks from 2009 to 2017 being described as the "most hated bull market in history" 

Even the experts can't seem to agree. Richard Buxton and Neil Woodford are star equities managers and they seem to predict different outcomes for the market in 2018. So even the experts can't agree on where the markets are going. Having a diversified portfolio insulates it somewhat from unpredictable market outcomes or having to make predictions in the first place.

Hedging price risk

In theory bond prices and stock prices are supposed to move in different directions relative to each other. Bond prices go down when stock prices go up and vice versa. So in a booming stock market, bonds serve as a drag on the portfolio's performance. However, when stock markets meltdown, as they eventually do, the bond portion of the portfolio helps to offset some of the losses.

In recent years, after the Lehman crisis, central bank action has caused stock and bond prices to rise in tandem. High Price-to-Earning (PE) ratios for stocks and low bond yields suggest both asset classes are overpriced.

This breakdown in the historical relation in prices means in the next downturn, both asset classes may suffer price declines, nullifying the natural hedging effect. This has led many commentators to declare the 60/40 allocation dead and suggest including other forms of asset into the mix, such as real estate or commodities. Although it is hard to deny that prices are high, we will see how these alternatives work out when the market downturn comes around.

A vital part of the asset allocation approach is the concept of re-balancing.

What is re-balancing?

One of the first steps in portfolio construction is to assess the investor's risk profile and investment objectives. This allows the construction of a portfolio based on the ideal mix or risk and return. Asset allocation is then determined, to construct the ideal mix of stocks, bonds or whatever for the based on this profile.

Restoring the risk profile of the portfolio 

Over time, however, as a portfolio’s investments produce different returns, the portfolio will likely drift from its target asset allocation. The portfolio's risk and return profile then becomes inconsistent with an investor’s investment objective. Re-balancing serves to bring the portfolio back into balance.

Hypothetically speaking, let's say a portfolio starts with a 60% stock and 40% bond allocation. At the end of the year, the stock market performed well and as a result, the value of the stocks rises to 70% of the portfolio's total value, leaving bonds with 30% of the total value of the portfolio. Re-balancing will require the investor to sell 10% of the stocks and re-invest the money into bonds. This brings the portfolio back to a 60% and 40% weighting at the end of the year.

A disciplined plan to buy low and sell high

As any seasoned investor well knows, to make money, you need to buy low and sell high. However , if you can't predict where the market is going, when and how much do you sell?

The discipline of re-balancing your portfolio removes this quandary for many people. You re-adjust periodically back to your starting equity/bond weighting without having to make decisions to over=-weight or under-weight. 

This also allows investors to buy when greed and fear are at their strongest. As the rule to making money market is buy low and sell high, you need to buy when prices at their low points. 

However, it is extremely difficult to overcome fear when there is blood (figuratively) on the street or to sell when prices are on a tear. Having a plan to rebalance periodically (and the discipline to stick to it) helps to overcome this.

So in summary, the 60/40 allocation may be under siege now, is a sensible way to invest worth considering, for those people who want their portfolios to survive long term, rather than provide lots of excitement. 

I wanted to show some stats of how a 60/40 allocation using Singapore ETFs would have worked out, but this post took far longer than expected. I'll do this in the next post. Thanks for reading.

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