Much ink has been spilled over the past year on the “death of the 60/40” portfolio, referring to a traditional 60% large-cap public market equity and 40% core fixed-income portfolio. Much of this angst was brought on by the increase in correlation between equity and fixed income in 2022, with both asset classes losing money on the year.
We believe a primary reason a public-only, 60/40 portfolio may no longer achieve wealth creation and retention goals of investors going forward is because of a fundamental misunderstanding between capital allocation and the contribution to risk.
For example, a 60/40 portfolio has experienced 9% volatility (measured by standard deviation) over the past two decades. When we decompose the risk of that 60/40 portfolio, what we find is that 98% of the ups and downs in that portfolio are driven by the 60% allocation to core equity.
Many investors, upon seeing this, assume that decreasing the allocation to equity and increasing the allocation to fixed income is the answer. That might look like a more conservative 40% equity and 60% fixed-income portfolio, with 6% volatility.;
However, when we decompose the risk of that more conservative 40/60 portfolio, what we find is that still 88% of the ups and downs are driven by just that 40% remaining allocation in core equity1.
Public-only portfolios may no longer deliver in large part due to embedded outsized equity risk.
So, we find that it does not matter if an investor is more aggressive or more conservative: If they have not properly diversified the risky core equity part of the portfolio, that investor could still find themselves overly impacted by the volatility of the equity markets (and therefore the news flow of CNBC or Bloomberg over the preceding weeks)2.
In fact, if the goal were to have an evenly diversified risk budget between equity and rate risk, the capital allocation becomes extreme:
We have seen many financial advisors do good work diversifying their portfolios’ company-specific risk through diversified exchange-traded funds (ETFs), manager selection, and manager overlap analysis, but still be dominated by broad equity risk.
Even if an investor’s starting point is much more diversified than a traditional 60/40 or 40/60, they may still experience an equity risk overload.
Even if your starting point is much more diversified than a traditional 60/40, you may still experience equity overload.
Because equity risk flavors so many asset classes, it takes hard work to moderate its influence in a portfolio.
Example "diversified" portfolio
We believe the solution to breaking away from this paradigm can be found by looking outside of the traditional stock and bond matrix to diversify core equity risk in a different way2. Private markets are one of those ways.
For more information on building diversified risk budgets and portfolios with private markets, please see our Private Markets Insights newsletter5.