Of all of the many clever things Mark Twain is alleged to have said, one of my favorites, especially these days, is: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
In the turmoil that is 2020, many market “truths” have morphed into myths. And many trusted investment adages no longer make sense.
One that continues to puzzle me is how many financial advisers still recommend the 60/40 portfolio balance between equities and bonds. Equities will give you growth, the theory goes. And bonds will give you income as well as provide a buffer in times of equity decline. If you want to preserve capital into your old age, we’re told, this is the diversification strategy for you.
That doesn’t hold any more.
Diversification itself is not on trial here. Whether you subscribe to chaos theory or just enjoy a balanced diet, diversification is a pretty good rule of thumb when it comes to a healthy lifestyle (except perhaps when it comes to marriage).
It’s the why of diversification when it comes to investments that we need to think about.
The idea is that diversification spreads risk. What hurts one asset might benefit another, or at least not hurt it quite so much. An asset could have unique value drivers that set its performance apart. And a position in low-risk, highly liquid products allows investors to cover contingencies and to take advantage of other investment opportunities when they arise.
All that still largely holds. What needs to be questioned are the assumptions that diversification should be spread between equities and bonds.
One of the main reasons for the equity/bonds allocation split is the need to hedge. Traditionally, equities and bonds move inversely. In an economic slump, central banks would lower interest rates to reanimate the economy. This would push up bond prices, which would partially offset the slump in equities, delivering a performance superior to that of an…