In general, asset classes that are riskier have delivered greater excess returns than those that are less risky. This should make sense since investors should pay attention to the level of compensation for a certain level of risk. Why would I take a lot of risk to earn just a little more return? As a result, historical asset‐class returns and risk are somewhat proportional: those with greater risk offer higher expected returns than those with less risk.
My ultimate goal in this book is to walk through an efficient way to capture the risk premiums available in various asset classes. That is, we wish to identify the best way to seek better returns than cash by investing in a diverse set of asset classes while minimizing risk. In fact, we seek returns much better than cash and want to be thoughtful about how to achieve this objective without taking undue risk.
It is important to note that there is no attempt to predict what the future economic environment may look like or which asset classes will be the best performers over the next market cycle. We want to be, by and large, indifferent to what environment transpires next and how it may shift through time. We are trying to identify a thoughtful, neutral portfolio that can stand the test of time through a passive long‐term allocation without the need for tactical decision‐making. In fact, the design of this balanced allocation assumes that the future twists and turns of the markets are inherently difficult to anticipate in advance. This is why it makes sense to maintain a well‐diversified portfolio at all times.
WHAT IS RISK?
The rate of return of an investment is a relatively straightforward notion to understand. You invest $100 and in one year your portfolio is worth $110. This means you earned a 10% return. Risk, on the other hand, is multifaceted and more challenging to observe and measure. I think of risk across three different dimensions:
1 Volatility
2 Probability of catastrophic loss
3 Odds of an extended period of poor returns
Volatility is the standard measure of risk in the investment industry. The technical metric is standard deviation, which is a statistical of the dispersion of an investment's price change around its average over time. The more the price fluctuates around its average return, the greater the volatility. In general, a lower volatility is preferred over a higher volatility for the same return because the odds of actually earning the average return improve. This is because investors are less likely to get in and out at inopportune times.
A major shortcoming of the volatility metric is that a return stream can exhibit reasonable volatility most of the time, but suddenly experience a major loss of capital. That is, the average may be acceptable yet understate extreme negative outcomes. Many experts have commented that highly improbable results seem to occur far more frequently than statistically expected. In other words, the notorious “100‐year flood” seems to hit financial markets far more often than once every 100 years. We've witnessed firsthand some of these outliers in the last three decades alone, with the 1999 tech bubble and bust, the 2008 global financial crisis, and the 2020 global pandemic. For this reason, the probability of a catastrophic loss should also be analyzed when considering the risk of a strategy.
Last, a longer‐term perspective of risk is justified. Consider that the volatility and distribution may be acceptable, but the average return could be low for an extended period of time. That is, the odds of poor returns over a long period (e.g., the so‐called lost decade in 1990s Japan) may be the most relevant risk. After all, investors may be able to live through the roller‐coaster ride associated with a precipitous drop and subsequent rebound, but 10 years of severe underperformance may be difficult to overcome. This is particularly relevant for investors who rely on a certain rate of return to fund annual expenses.
A well‐balanced portfolio should be structured to minimize all three aforementioned risks for a desired long‐term return objective. All three risks are pertinent and worth consideration because each can have a material negative impact on investors.
THE 60/40 PORTFOLIO IS NOT WELL‐BALANCED
The conventional “balanced” portfolio is made up of 60% stocks and 40% intermediate‐term bonds. This allocation is commonly used in finance books and the media as a representation of a typical portfolio. In fact, there are hundreds of professionally managed strategies that benchmark to the 60/40 portfolio and use “balanced” in their title. However, a simple high‐level risk analysis using the definition just presented will reveal that the 60/40 portfolio is actually very poorly balanced.
The 60/40 portfolio scores poorly across the three dimensions of risk just described. The level of volatility is greater than necessary for the expected return. This point will become more apparent when I describe the risk parity portfolio later in the book. This conventional balanced allocation is also prone to significant losses and long stretches of underperformance, since its returns are almost entirely dependent on the stock market, which serves as the core return driver. A statistic that surprises many investors is that a 60/40 portfolio is over 95% correlated to a 100% equity allocation. For instance, the 60/40 portfolio experienced steep declines along with equities during the first quarter of 2020 (–12%) and during the Global Financial Crisis of 2008–2009 (–35%), and it grossly underperformed most investors' objectives during the entire decade of the 2000s (earning less than 3% per year and falling slightly behind cash over 10 years) as global stocks suffered negative returns for 10 years. Regardless, few practitioners raise concerns about the lack of balance in the 60/40 portfolio, and even fewer argue that the typical “balanced fund” is effectively engaged in false advertising.
In my experience, most investors don't really appreciate what diversification means. There appears to be an overemphasis on the number of line items as opposed to how diversifying each investment is relative to other holdings. They may think that they are diversifying by allocating to assets with slightly different characteristics or to funds with different managers (e.g., US small‐cap equities, US large‐cap, Vanguard, Fidelity, etc.), but all of those allocations tend to be highly correlated to each other. In other words, the differences many investors focus on are largely immaterial. As a result, they allocate to assets that all behave more or less the same way and barely diversify each other at all.
If the 60/40 portfolio is so poorly balanced, then how did it become the conventional balanced portfolio? A description of how this allocation evolved to become the convention and the thought process that backs its construction is warranted. The logic makes perfect sense, which explains why it has prevailed, and its place atop the balanced hierarchy has rarely been challenged.
We must go back to the story of Ray and his view that the starting point for most people is where others left off as opposed to a full reexamination of the central assumptions. When investors look to build a portfolio, they consider a menu of options. The typical choices include various equity and fixed income segments, because stocks and bonds represent the backbone of finance. Companies generally issue equity or debt to raise capital, and investors have the opportunity to own a piece of each in order to participate in the prosperity of the global economy. Throw in a strong bull market over the past decade and a remarkable run for both asset classes during the 1980s and 1990s as interest rates declined, and we can see why stocks and bonds as core menu options have persisted for so long.
Stocks offer high expected returns with high risk. Traditional fixed income such as intermediate‐duration government and high‐quality corporate bonds have lower anticipated returns with lower risk. With these two choices, investors can scale the risk of their portfolio up and down by adjusting the allocation between these two major asset classes. Those who have a high threshold for risk and/or a long time horizon may opt for 100% stocks, whereas investors who are more