“Enough with this diversification talk, I’ve got my 60/40 and I am happy!” The 60/40 stock/bond portfolio mix has become a standard reference or benchmark for many investors, yet its performance versus a truly diversified portfolio is mixed.
The diversified portfolio present above (high yield, TIPS, EM bonds, EM equities, REITs, and commodities equally weighted) is just one alternative diversifying mix of assets; nevertheless, the sample above shows that an equal weighted portfolio will do better than a 60/40 stock/bond mix (S&P 500/Barclays Agg) about 2/3rds of the time. You could say that the positive opinion towards the 60/40 blend is a recency bias with it outperforming a diversified basket four of the last five years not including the partial 2017 year.
The periods when there have been extended outperformance of the 60/40 blend relative to the diversified portfolio has been centered when there has been equity overvaluation in the US markets; mid-80’s before the 1987 crash, late 90’s before the tech bubble, and the more recent period when US stocks have seen significant gains in asset inflation.
There are a number of ways to beat the simple 60/40 blend in the long-run. One, add diversifying assets from the list used in the graph above. However, the excess return was based on the fully diversified portfolio versus the 60/40 blend. Two, add hedge fund strategies that have diversification of assets along with diversification of style. This, for example, could be a portfolio of managed futures programs which already are globally diversified across a broad set of markets including equities, bonds, rates, currencies and commodities. Along with the asset class diversification, investors get strategy diversification that will often weight long and short positions by trends. The advantage of managed futures is that there is the opportunity for adding convexity or portfolio gamma.
The combination of a strong US stock market with a diversification from bonds has made for successful return to risk combination, but as we have seen, there are no guarantees that this combination will always do well. Further diversification will better manage risk but also allow for higher returns especially after periods of one-sided performance.