A different world

Both geo-economically and geopolitically, much has changed in recent years. In light of events such as the COVID-19 pandemic and Russia’s invasion of Ukraine, terms such as “polycrisis” and “permacrisis” have entered the narrative. Many of the conditions that gave rise to the golden age of investing no longer apply.

Beginning in the early 1980s, as explained in the preceding section, investors became accustomed to total return levels that were previously unimaginable. Looking ahead, it is hard to believe this could happen to the same extent. Higher inflation and soaring interest rates have translated into greater positive correlation between equities and bonds, which have fallen in tandem in 2022.

Since the end of March 2009 to end of 2021, as shown in Figure 2, global equities and global bonds have delivered average annualised returns of 14.2% and 3.6% respectively ². Over the course of the next decade, according to the Capital Market Assumptions* produced by the Invesco Investment Solutions team, global bonds are likely to yield somewhat better returns (c. 4.8%) though at 6.9%, the Figures are likely to be considerably lower for equities.

More broadly, bonds’ reputation as a safe-haven asset able to provide downside mitigation has been undermined. For decades the prospect of the yield curve moving by a hundred basis points was practically unthinkable, yet this happened several times during 2022. What was once essentially viewed as a risk-free investment has shown itself capable of equity-like drawdowns.

Taking all the above into account, it is clear the diversification benefits that once underpinned the thinking behind a 60/40 portfolio have diminished. This means the traditional “balance” that worked so well in the past might not work so well today or in the future.

For much of 2022 it appeared 60/40 portfolios would suffer their worst-ever year³. Although they eventually avoided this fate, the argument that the golden age’s go-to strategy is “dead” has gained ground⁴.

We do not suggest a 60/40 portfolio may never again help investors meet their objectives. It is rarely prudent to dismiss anything out of hand, and there is always a possibility that what shone before could one day shine again. We do believe, though, that serious thought should be given to other approaches.

The bigger picture

One possible response to what might be seen as a 60/40 portfolio’s loss of balance would be to markedly adjust the ratio of equities to bonds. If the latter are not offering enough downside mitigation, for instance, why not move to a 70/30 or even an 80/20 allocation?

In reality, of course, this is easier said than done, as a client’s risk tolerances might not permit such a shift. We therefore need to utilise other approaches to asset allocation.

This means we need to think creatively. We need to construct multi-asset portfolios in ways that embed flexibility and can better enable us to navigate uncertain times. In short: we need to consider the bigger picture. Below are some key examples of this thinking.

Geographic diversification

Just as they can benefit from diversifying across asset classes, investors can benefit from diversifying across regions. It may now be especially useful to pay attention to how different regions are valued versus both their own history and other regions. Home bias – the tendency to invest the majority of a portfolio in domestic assets – is still widespread⁵, even though such an approach ignores geographic diversification’s potential to help maximise opportunity and minimise risk.

Smaller companies

While many investors’ view of the equities universe is limited to large-cap businesses, the small-cap space is home to some of the most promising opportunities to be found anywhere on the market-cap spectrum. Small-caps are often under-researched and under-owned, and they routinely outperform their large-cap counterparts over time – even though they are likely to be more volatile over the short term.

Superior sources of income

Looking further afield and digging deeper can help address the issue of income, too. This is because income can also vary across regions and sectors. For example, exposure to UK equities brought attractive levels of dividend yield during much of 2022, while exposure to energy and utilities went a long way to offsetting relatively disappointing income from technology and industrials. This point also applies to fixed income, where assets such as high-yield bonds are gaining more attention – although risk considerations must obviously be taken into account.

Alternative asset classes

We should not forget the investment universe extends beyond equities and bonds. Alternative asset classes include real estate, commodities, hedge funds and private equity. While not every investment is suitable for every investor, it is vital to understand markets are non-homogenous – as illustrated in the Figure 3 – and a healthy blend can therefore help a multi-asset portfolio perform consistently, not least during periods of uncertainty and volatility.

Active management

A traditional 60/40 portfolio is invested passively. Going forward, with greater volatility expected, the role of active managers in attempting to identify likely winners – and, perhaps even more importantly, avoid likely losers – could become more significant. Active management can be particularly helpful when the differential between best-performing and worst-performing sectors becomes unusually stretched, as is the case at present.