Given the low yield environment, is there still a role for traditional diversifiers (such as bonds) in today's balanced portfolio?

A recent narrative questioning the merit of a diversified portfolio of traditional equities and bonds has had many in the investment management industry asking: "Is the 60/40 portfolio dead?".

Generally referred to as a balanced portfolio, "60/40" refers to a mix of 60% equities and 40% bonds. It is a universal portfolio construct designed to deliver sufficient returns for a range of investor goals while providing adequate diversification to satisfy the risk tolerance of the investor. Importantly, 60/40 is a guide only, with the exact mix of equities and bonds driven by the investor's return requirements, risk tolerance, time frame and other factors that a qualified financial adviser is well placed to assess.

At the heart of the debate however is a question more fundamental than the exact asset allocation mix. And that is whether or not there is still a role for traditional diversifiers, such as bonds, in today's balanced portfolio, given the low yield environment we are expecting for years to come.

The 60/40 portfolio is not dead, and nor is it on life support. What should be put to bed however are unrealistic expectations of returns from a well-diversified portfolio given current market conditions.

Over the past decade, downward pressure on inflation and unprecedented levels of central bank stimulus have seen 10-year government bond yields fall from 5% to just 1.6%. Similarly, the stellar performance of riskier assets (such as shares, property and infrastructure) over this same period cannot last forever, and may likely see reduced returns in the future.

But while the outlook for both equities and bonds is likely lower from here, it doesn't invalidate the principles of diversification that remain well-served by an allocation to high quality government and corporate bonds.

Lower return expectations have resulted in some investors, both professional and non-professional, migrating up the risk spectrum to chase returns at the expense of portfolio risk. While the market volatility that unsettled investors in March and April last year was relatively short lived, it served to underscore the importance of maintaining bonds in the portfolio. Holding an allocation to high quality bonds during the period of volatility enabled disciplined investors to maintain their target asset allocation by selling a portion of their bonds to purchase shares, which fell as much as 37% during the first quarter of 2020.

Take for example, two identical diversified funds with a 60/40 asset allocation, where one was regularly rebalanced during the 6-month period from the start of March 2020, and the other wasn't rebalanced at all. The cumulative return difference of the rebalanced portfolio was more than 1% above that of the non-rebalanced portfolio – which is "low hanging fruit", particularly for investors nearing or already in retirement.

For professionally managed diversified funds, asset allocation is monitored daily and the portfolio rebalanced regularly to ensure the risk in the portfolio remains consistent. During periods of volatility, the portfolio will be well placed to capitalise on any future recovery in shares.

And while bond yields have recently risen following expectations of a pick-up in inflation as global economies recover from the depths of the pandemic, return expectations remain well below historic levels. Given lower expected returns, it is important that investors see the role of bonds as a diversifier of portfolio risk, with shares still likely to do the heavy lifting when it comes to delivering return requirements.

The temptation can exist to over-extend portfolio risk to achieve a goal quicker but investors should be forewarned that taking on excessive risk can often result in poor decision making. Instead of rebalancing, as in the earlier example, investors can often cave in on their goal and sell out at the bottom, sometimes sacrificing years of potential returns in the process. In the prior example, the non-rebalanced portfolio lost 1% compared to the rebalanced portfolio but in a scenario where an investor moved all of their portfolio to cash at the bottom of the market during April 2020, the cumulative cost thus far would have been just shy of 40%!

And so, while the 60/40 portfolio may require some extra patience to achieve your financial goals, whether that be retirement, a first home or a post-pandemic holiday, the consequences of taking on excessive risk could jeopardise achievement of your goal entirely - a hefty long-term penalty to pay for a short-term gain.

An iteration of this article was first published in the AFR on 8 June 2021.

 

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