April 24, 2012
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives. A version of this article appeared originally in the November-December 2011 issue of the IMCA Investments and Wealth Management magazine.
Maintaining a balanced portfolio is critical, especially when predictions of growth and inflation vary as widely as they do today. Investors are always better off spreading risk than aggressively betting on one economic outcome, and that’s especially true when the range of possible economic outcomes is so wide.
This article will discuss the benefits of an “environmentally balanced” portfolio – one that’s truly prepared for any outcome. Using statistical analysis, we’ll assess this strategy’s usefulness by comparing historical returns, and we’ll also consider how to put these ideas into practice. But first it’s important to understand the concepts that underpin such a portfolio, and how to think about constructing one.
Building a balanced portfolio
Before discussing what is environmentally balanced, let us briefly discuss what is not. Surprisingly, the classic asset allocation – 60% equities and 40% bonds – is not a balanced mix. In fact, from an environmental risk perspective, it’s not much better than an equity-only portfolio.
That’s because the correlation between 60/40 and 100% in equities is 98%.1 That is not a typo. These two portfolios, most investment professionals are surprised to learn, go up and down in near-perfect tandem. Equities are so much more volatile than bonds that they drive the entire portfolio’s returns. Consequently, 60/40 is not environmentally balanced, because it does well only in economic environments where equities generally outperform (i.e., during periods of rising growth and/or falling inflation).
The economic environment drives asset class returns. Economic growth and inflation are the two key factors that influence how stocks, bonds and other asset classes perform. For instance, an economy that experiences rising growth (or grows faster than the market has discounted2) is generally bullish for equities, as their profits and margins rise. Falling inflation also helps stocks by improving margins, lowering costs, and reducing borrowing costs and interest rates. Bonds do well when growth is weak because of their safe-haven status and the increasing likelihood of falling interest rates. Lower inflation also benefits bonds, because interest rates decline. Similarly, the returns of other asset classes, such as commodities and inflation-linked bonds, also depend strongly on the economic environment.
Grasping the concepts behind a balanced portfolio must begin with understanding the relationship between asset class returns and the economic environment, as well as with two key decisions: which asset classes to own, and what percentage to allocate to each.
As to the question of which asset classes to own, it’s important to have a combination of asset classes that perform well in different economic environments. The following four asset classes provide a good starting point:
- Equities
- Long-term Treasury bonds
- Long-term inflation-linked bonds (TIPS or Treasury inflation-protected securities)
- Commodities
Stocks and commodities tend to outperform when growth is rising; long-term Treasuries and TIPS do well when growth is falling; TIPS and commodities produce strong results when inflation is rising; and stocks and Treasuries do well when inflation is falling. Two of these four asset classes tend to outperform in each of the four economic environments (rising/falling growth and inflation), as displayed in table 1.
1. Correlation is calculated using monthly returns since 1926. Equity returns consist of the S&P 500 Index. Bond returns use a combination of the Barclays U.S. Aggregate Bond Index from its inception on 1/1/76 through 12/31/10 and the U.S. Treasury constant 10-year maturity index from 12/31/26 to 12/31/75. Data provided by Bloomberg.
2. Asset class prices reflect a set of expected outcomes. The key driver of security price performance is how the future plays out relative to those expectations. For example, if 6% gross domestic product (GDP) growth is priced into the equity market over the next year and we experience only 4% GDP growth during that period, then equity prices may decline as this reality becomes apparent. This may be true in spite of the fact that 4% GDP growth still may reflect relatively strong growth. In reality, growth is “rising” above expectations about half the time and “falling” below discounted measures about half the time. Likewise, inflation is “rising” about half the time and “falling” about half the time.
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