Sauer: Is 60/40 Extinct?
Courtesy of Matt Sauer, MFSWNB Investments:
A recent financial market pundit described the current market conditions by using Darwin’s phrase “survival of the fittest”. Perhaps the biggest lesson out of Darwin’s work is not that evolution is a battle but one of adaptation. The long-term winners are better at adapting to changing circumstances rather than battling with others in the same ecosystem. We have pointed out the virtues of Amazon and Tesla as companies capable of adapting.
While far sighted entrepreneurs may be capable of navigating changing conditions, a certain element of our society must adapt quickly or risk severely impairing the institutions dependent on their decision making-the Investment Committee.
Read the investment policy of any institution and there will be acceptable ranges of ownership levels of stocks and bonds. Those ranges almost always state that equities shall be owned in a range of 50-70% of the portfolio and bonds 30-50%. (While larger institutions may incorporate private equity and venture capital, that is usually not the case for many smaller entities.)
These numbers are based on the common (and mythological) 60/40 portfolio. Treated as divine inspiration, it is commonplace because it is easy, and it has worked. There are very few people working on Wall Street that have not watched interest rates gently roll down (measured on a 5year rolling average) in yield on a 10- year Treasury of 12.46% on Halloween of 1980 to approximately .65% this Halloween. Every consultant to every Investment Committee has been able to advocate significant percentages of the portfolio suggesting that the bonds dampen volatility and produce acceptable returns. The same consultants preach reversion to the mean in asset class returns but never explain what the mean yield is. Is it 1980’s 12.46% or last year’s 1.4%?
Where are we today? Is it prudent to lock up 40% of a portfolio in an asset class that has negative real returns and possibly negative nominal returns within any acceptable time frame? Will bonds really dampen volatility? Is credit risk a solution? Without utilizing private equity and venture capital, are stocks the only acceptable investment?
Darwin was well known for observation. He also had a maxim that if he observed something inconsistent with his beliefs that he would write it down immediately before his mind convinced itself that the observation never happened.
Wall Street is known for disregarding observations inconsistent with their beliefs because the game is to understand the belief systems of others and exploit them by preaching reversion to the mean instead of understanding that the mean has been a moving target for forty years. Suggest that the initial conditions are changing, and one will be laughed at with the well-worn phrase “…the biggest way to lose money is to say this time is different…”. What if it is different this time?
Investment Committees exist to demonstrate an ability to make prudent decisions for the benefit of an institution. Members of the committee usually check their own market forecasts at the door, it is easier not to have a view of the market than to be labeled wrong later. Many times, in order to avoid being wrong, the committee uses historic data. The presence of immutable data from the past never runs into Darwin’s dilemma of observing a data point inconsistent with their own beliefs, however it is inconsistent with the market’s beliefs.
Unless almost all the Investment Policies are immediately rewritten, the assumptions constructing a 60/40 portfolio are going to undermine the goals of the institution. We doubt that any movement will be made in that direction, therefore there will be carnage across the balance sheets of non-profits and foundations.
The noted “Wealth Gap” in our society is the result of 40 years of double digit returns in stocks and bonds with inflation migrating from high single digits to under 2%. Although this outcome has been used a political capital in looking at wealth creation in households, it is also relevant to foundations and non-profit organizations. The growth in endowments has allowed the institution to believe that past spending practices may be acceptable to forecast because of the existence of the historical returns. This is simply not the case.
How long will it take to right size expectations with reality? The answer is that it takes courage and bold convictions, two items in short supply on Investment Committees.
--Matt Sauer, MWSWNB Investments. Originally published here.