What’s wrong with the 60/40 portfolio?


Investors who were aware of the advantages of diversification traditionally looked to the 60/40 portfolio as a ready-made mechanism through which to harvest these benefits.

The 60/40 portfolio consisted of 60% equities balanced against 40% of bonds, with the core idea being the slightly larger allocation towards equities could provide the potential for capital growth over time, whilst the slow but steady 40% allocated to bonds would provide the stability.

Some wealth advisors tinkered with the formula, proposing a reversed 60% bonds to 40% equities for example for especially risk-averse investors.  However, this general concept of the two-asset class diversified portfolio has proved remarkably durable and still forms the backbone of many investors' broad approach to diversification to this day.

Whilst this approach has its merits, we believe that it needs to be updated and modified in light of the highly unusual macroeconomic situation we find ourselves in today.

Why aren’t stocks and bonds enough anymore?

Essentially, we believe much of the investment wisdom that held true for the past decade will now no longer prove valid given the fundamental change in the direction of monetary policy brought on by the global surge in inflation.

In the fight to bring inflation down anywhere near to the 2% target, interest rates will certainly need to rise further than their current levels, and this means both the bull market enjoyed by stocks and bonds simultaneously since 2009 is over.  Whilst it is obvious that weak economic data from around the world combined with higher interest rates that reign in spending will weigh on stock valuations, the mechanism by which these changes will impact the bond market is less clear-cut.

Put simply, now that borrowing costs are starting to rise and central banks are beginning to withdraw their buying power from the secondary debt markets, it is inevitable that bond prices will fall and yields will rise.

This is far from bad news in itself, but the generally tighter monetary conditions we are rapidly heading into will lead to a ‘repricing’ of risk, whereby investments that looked attractive in a context of almost zero interest rates no longer have the same shine.

Crucially, these developments are quite likely to lead to a situation where both stocks and bonds are simultaneously declining in absolute terms, and this is why the classic 60/40 portfolio simply doesn’t look likely to provide enough diversification today or tomorrow.

Diversification means alternatives

Perhaps the problem isn’t so much the 60/40 portfolio itself – it does make sense to split assets between a ‘racy’, growth-focused section and a steadier, more defensive portion.

Our view at Shojin is really that to avoid disappointment and unpleasant surprises, investors today need to diversify further and deeper than simply stacking stocks against bonds.

The good news is real estate can augment both the dominant 60% capital appreciation-seeking component of a diversified portfolio, as well as strengthening the defensive, hedging 40% as well.

As such, there isn’t necessarily anything wrong with the 60/40 portfolio in and of itself – the problem is with relying exclusively on stocks and bonds to fill this portfolio.

Real estate assets find willing buyers from across the financial landscape

Aside from high-net-worth individuals who have always appreciated the virtues of property as an investment, real estate assets in 2022 are summoning up increasing demand from an enormous variety of financial institutions.

Blackstone, the world’s largest alternative asset manager, earlier this year completed the acquisition of one of the biggest portfolios of US student housing, American Campus Communities.  Valued at around $13 billion, the deal continues Blackstone’s streak of buyouts which has seen the group bringing more and more real estate assets under its control.

Similarly, a recent survey conducted by UBS found that around the world family offices are allocating a growing portion of their capital to the alternative sector, and that within this real estate was playing a major role.  Real estate investments now represent an average of 12% share of a family office portfolio, with fixed income only slightly ahead of this at an average of 15%.  The trajectory will possibly see real estate overtake fixed income securities as a share of portfolios at some point, as bonds decline in proportional terms and property rises.

This increasing allocation towards alternatives in general, and real estate assets in particular, is far from exclusive to family offices or global asset management giants.  Even much more conservative government-backed pension schemes are outlining how and why they are set to grow their exposure to long-term real estate assets considerably in the years ahead.

What is it that is attracting this diverse range of buyers to real estate as an asset class with a growing urgency today?

Real estate – the ultimate diversifier

All these buyers are attracted by the unique combination of capital appreciation and steady income that makes real estate assets such a powerful way to achieve diversification.

The fact that the performance of real estate investment is made up of two separate components, property value appreciation and recurring cash flows, means that the asset class can potentially perform well in any macroeconomic climate.

All else being equal, property values should appreciate with economic growth, as more people experience higher incomes and rising consumer confidence leads to increased demand for houses.  Thus, in an inflationary context where it is strong aggregate demand that is dragging up prices, real estate assets should more than keep pace with this and therefore can be expected to offer strong capital appreciation when the economy is healthy.

However, unlike stocks that risk going into a tailspin when recession looms, or bonds whose valuation is at the mercy of central bank policy aimed at controlling inflation and therefore not even directly considering its impact on bond values, real estate can offer a great deal in times of subdued or even negative economic growth as well.

This is because the income yielded by property can be expected to hold up during times of economic malaise, and for properties with leases that reset frequently like buy-to-let or purpose-built accommodation, the rental income received should rise in line with inflation.

Those characteristics of the asset class when combined with careful management by an investment agent give real estate its unique ability to simultaneously add growth and stability to a portfolio, and thus to achieve the Holy Grail of investing – diversification beyond that offered by the classic 60/40 portfolio containing only stocks and bonds.