Morgan Stanley’s chief investment officer Mike Wilson recently made headlines by recommending that investors move away from the traditional 60/40 equity/bond portfolio, suggesting instead a 60/20/20 mix where gold replaces half of the bond allocation.
While we’ve been arguing for years about the merits of diversifying away from the 60/40 portfolio (see Rethinking the 60/40 portfolio) it seems the mainstream is only belatedly reaching the same conclusion.
Why Bonds no longer deliver
It has long been apparent that bonds have become an increasingly poor choice for offsetting equity risk. While bond investors benefited from the slow decline of interest rates from the early 80’s, returns in recent times have been slim at best. In fact, investment grade bonds returns have averaged only 3.5% per year over the last 25 years.
Although bonds have historically been counted on to provide an offset when equity markets performed poorly, the experience of 2022, when bonds fell almost 15 percent, demonstrated this can no longer be relied on. The negative correlation between bonds and equities, once a cornerstone of the 60/40 model, appears to have broken down.
Gold returns to favour
With bonds looking less appealing, investors have turned to alternative assets classes, with gold proving a popular choice. For historical and cultural reasons gold has often been viewed as a store of wealth, particularly during periods of economic turmoil. Unsurprisingly, gold has surged in value in the current environment, due to ongoing trade wars, civil unrest and rising government deficits.
With expanding government debt and slowing growth, many argue the only solution is to inflate the debt away. In a world where currencies are losing their purchasing power the demand for inflation hedges has grown. Hence Wilson’s call for a 20 percent allocation to gold. He remarked, “Gold is now the anti-fragile asset to own, rather than Treasuries. High-quality equities and gold are the best hedges.”
While we echo the sentiment it does beg the question, why would investors make such a large allocation to an asset that has risen almost 80 percent in the past two years. Additionally, it is difficult to make a strong case for gold as it is a non-yielding asset. That is, unlike most investments which deliver dividends, interest or rent, the returns from gold are solely from price appreciation driven by supply and demand.
Gold has many attractive features as a diversifying asset, namely its low correlation with equites, but it also comes with high volatility and sharp drawdowns, as evidenced by the following table showing performance over the past 25-years.
As the table illustrates, the strong recent performance of gold means a 20 percent allocation to gold would have increased a balanced portfolio’s annual return over the past 25-years from 5.9% to 7.5% with only a modest increase in volatility. However, it is notable that this made little difference to the maximum drawdown (-32.2% compared to -33.7% for the 60/40 portfolio), since most of the risk comes for the 60% allocation to equites.
Managing the next big drawdown
How should investors manage the risk of another stomach-churning drawdown?
The answer is obvious, diversification, much more diversification.
By adding additional uncorrelated assets to a portfolio, the maximum expected drawdown is dramatically reduced, even if individual assets occasionally experience large losses.
As the following chart shows, while a single asset may have a maximum drawdown of –40%, this falls to –28% if we have two uncorrelated assets and -12.6% if we have a portfolio of 10 uncorrelated assets.
The caveat here is the diversifying assets must be reliably uncorrelated. It is a widely used saying in financial markets that in times of turmoil “correlations go to 1”, assets that have historically moved independently suddenly move together. When fear grips markets, investors often rush for the exits, creating feedback loops where price drops drive further selling. In extreme events such as the Global Financial Crisis or the Covid Crisis, even gold wasn’t immune as forced selling spread losses across markets.
Diversification beyond 60/40
It is for this reason that we believe diversification is one of the most important considerations when investing. Diversification doesn’t mean holding traditional assets in different sectors or countries, true diversification means investing across different strategies that can reliably be expected to behave differently, even in extreme events.
This search for greater diversification has inevitably led us to the world of alternative investments. This includes areas outside traditional equity and bond investing, such as private assets, hedge funds and commodities, as well as strategies that provide a far more robust defence.
While the 60/20/20 portfolio is a step in the right direction, in our view swapping half your bonds for gold doesn’t go nearly far enough. By building portfolios around a broader set of alternative assets, it is possible to deliver the stability, growth and resilience that the 60/40 was once thought to provide but no longer can.
Get in touch with Mark or Sam if you’d like to discuss the themes of this article in more detail.