The Boar is on the Floor

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Most people have never heard of the 60/40 investment portfolio. That’s surprising because most people have some version of it in their 401k or retirement portfolio as a Target Date Fund. If you use a typical investment advisor, s/he’ll construct something in the 60/40 zip code. Wealthfront, Betterment, and other “robo” advisors offer the same.

Disclaimer up front: I am not a financial or investment advisor. I don’t even play one on TV. I’m telling you want I have learned through my research and what I do and think personally. You have to do your own research.

What is a 60/40 Portfolio?

It’s basically 60% stocks and 40% bonds. The idea emerged out of what’s called Modern Portfolio Theory developed by a U of Chicago professor and Noble Laureate named Harry Markowitz² . Markowitz showed that by blending together assets with low correlation (that don’t go up and down in value at the same time) you can create a more efficient investment portfolio.

Stocks give you more return so you want more of them but they are riskier. Bonds are safer but return less so you use them to make sure you can survive large drawdowns in stocks like in 2020 or 2009, etc.¹

On the bond side you could have a mix of corporate, mortgage, and treasury bonds or classically just treasuries. Treasuries (or US government debt) have the added advantage of not just maintaining value but tending to go up in value during times when stocks are plunging (although there are exceptions). That’s because when investors get scared they want the safety of the US government despite its large debts.

As you can see here the 60/40’s done pretty well. CAIA uses a database called CRSP to show that since 1961 stocks have returned 10.3% per year on average, bonds 6.7%, and the two combined at a 60/40 ratio gave you 9.3%.

So why not just own stocks? You got a higher average return. That’s where the Volatility and Sharpe Ratio lines come in. Stocks are much more volatile than bonds. Volatility means they go up and down in value by more.

It’s tempting to say you can sit there and watch 50% of your portfolio evaporate without freaking out but most people can’t. Stocks can also underperform for long periods of time-a decade or longer. It’s hard to imagine anyone feeling great about their bet in year 9 of underperformance.

The bonds help lessen that blow and give you something to sell when you need to buy more stocks after the downturn to rebalance to a 60/40 ratio.

What’s Wrong with 60/40?

If the portfolio returns well and minimizes drawdowns, why mess with it? Why do we need a new 60/40? The problem is this:

After 20 plus years of bonds going up when stocks go down, we had a dramatic reversal in 2022. The 60/40 portfolio lost over 17%, its worst performance since the 1930s, as both stocks and bonds went down at the same time.

What happened?

One word: inflation.

Inflation is terrible for bonds and stocks and bonds tend to correlate (move together) during inflationary times. It’s pretty clear from the chart above that this isn’t the first time this correlation has happened. An investor in 1995 looking back at the last 20-30 years would have assumed a high likelihood of stock and bond correlation.

You can also see from the chart that these periods tend to last for a while. One of the themes of this newsletter is that inflation is going to be higher and move around a lot more than it has for the last 30 plus years.

I think we’re going back to a time much more like the 1975-1995 part of the chart.

What’s the Solution?

I think of building an investment portfolio the same way you would a team or as a family. Let’s use America’s most dysfunctional, fictional family, the Roys, from the HBO show Succession as our example.

The show revolves around the aging patriarch, Logan Roy, who owns a media and entertainment empire. He’s the key driver that built the business. In our analogy he is stocks.

The story of the show is the story of who will succeed him. Each of his children have something to offer.

Kendall: He’s the oldest son and the one most familiar with business. As the show opens he seems to have been playing a prominent role at the firm, Waystar Royco, for many years. None of the other kids seem to have been involved that much. Kendall is bonds. He’s been around the longest and knows the most. He can actually run the business.

Siobhan “Shiv” Roy: She’s the daughter and has rejected the business by becoming a Democratic campaign/media consultant. The Roy’s own a fictional version of Fox News so this is a full rejection but she has her father’s political and PR acumen. Shiv is doing her own thing out somewhere else so we’ll call her gold.

Roman Roy: Rome is the younger son and a little weird. He has some strange sexual hangups and always seems to do something bizarre when the chips are down. On the positive side he has his father’s ability to understand other people and build relationships. We’ll call him managed futures or commodities.

Those are the three candidates to diversify the father Logan. There is actually a fourth kid from another mother, Connor. Everyone forgets about Connor including his other siblings and no one would ever let him near the company. He’s a side project that’s entertaining but won’t amount to much. He’s crypto and has no role in our portfolio beyond amusement.

Boar on the Floor

To make the company work, you want Logan at the center. However, in the first season, Logan has a stroke and is confused. He’s unable to perform his duties in the aftermath.

During times like this you want your bonds or Kendall to help out. He knows the business best. The downside is that Kendall will go on a drug binge from time to time and you can’t count on him during those periods. Usually those things happen a different times but, as in 2022, sometimes they coincide.

That’s when you need Shiv and Rome. Gold (Shiv) has been on a tear recently. Gold is confusing³ and can go through decades of under performance. However, it’s still worth having. Gold will outperform bonds when stocks go down about half the time. It tends to do well when investors believe that interest rates are too low for the level of inflation in the economy but there are endless discussions about what drives gold’s performance.

I couldn’t find a great up to date chart showing gold’s performance but this one from Van Eck will give you the general idea. As you can see gold outperformed during the 1970s and then struggle for about 20 years. This chart ends in 2014 but you would see is continuing underperformance until the 2020s. Since then gold has gone crazy. The message is that including it in the optimized portfolio helped over long periods of time.

Your other option when stocks and bonds are both incapacitated is real assets like commodities (oil, wheat, soy, etc.). Just like Rome, they have long periods of time when they are out of favor. That makes it hard to put them in charge.

In the show, Logan and others try to balance out Roman with the company’s general counsel, Gerri. She’s a strange combo of mother figure and sexual interest for Roman and can get him operating effectively for periods of time.

You can kind of do the same thing with commodities by owning futures contracts⁵ instead of the commodities themselves. It’s complicated but investors will try to follow the trend in commodities. Is sugar or palm oil going up or down in value over a period of time like 200 days?

If it’s going up, you buy futures contracts that bet on the price going up. If it’s going down, I can bet on the price going down and make money. This is called going long or short the commodity. It’s a futures based strategy so it’s called managed futures.⁴

By being long or short, you can make money no matter what the actual performance of the underlying commodity is and managed futures have very low correlation to bonds and even lower correlation to stocks.

Gerri is the futures. Rome alone will be mostly negative (just like commodities) but with Gerri he can perform when he’s most needed. Similarly managed futures will work overall but there are times like the 2010s where Rome will be in the closet for his screw ups.

As you can see in this chart from Morgan Stanley, managed futures did really well during times when stocks and bonds tended to correlate or move in the same direction together but not every time. Around 2004, managed futures did great but stocks and bonds remained uncorrelated. Notice that 2012-2020 time period. It wasn’t fun owning managed futures then.

Implementing the New 60/40

Again, I am not an investment advisor. I think most investment advisors suck and don’t understand how markets work. They are mostly salespeople but they are also realists. Most people do not own managed futures and gold because advisors know that clients look at short term performance. Usually the last three years if they are lucky and the last five years max.

As I pointed out earlier in the piece, cycles play out over much longer time frames of 30-40 years. I believe we have now entered a new cycle and that assets like gold and managed futures will be more important. However, I could easily be wrong so you have to make your own call.

Just look at the past year. I’ve been right about gold (it has outperformed stocks) but managed futures have trailed bond performance. You have to take a long view and not obsess about short term moves to invest effectively.

Another reason people haven’t owned managed futures in particular is that until recently it was a hard strategy to access for every day investors. It was the domain of hedge funds with high fees that only institutional clients like pension funds had access to.

Over the last decade and, in particular the last five years, managed futures has come to the ETF world with offerings like CTA, KMLM, DBMF, and others and fees below 1%. These are active strategies so you are almost always going to have to pay more than your typical Vanguard S&P 500 etf.

The other question is how much to allocate to each strategy? Again, that’s up to you. I tend to think we know very little about the future and so I just do a third each. If I’m sticking to a 60/40 like structure, I’ll put 60% of my money in stocks and then allocate 13% each into gold (I use the GLD etf), 13% into a low cost intermediate term treasury etf like IEF or VGIT, and 13% into a managed futures etf. I use CTA because it focuses more on commodities and I like the firm but KMLM and DBMF are great too. Add the extra one percent to which ever one you want. Dealer’s choice.

That’s my ideal allocation. If I’m being totally honest, I am not holding intermediate to long-term treasuries right now⁶ . I think the Fed made a mistake in starting to cut rates too aggressively and that bonds will get punished.

I also believe that the US will be forced to allow inflation to remain above the interest rate treasuries pay in order to inflate away our federal debt. If you let inflation run at 4% but only pay 2.5-3% in interest you are slowly devaluing the debt as a percentage of GDP. This is called financial repression and it will be the subject of another post. That’s also bad for bonds.

To be clear, this is rank market timing. Most people lose market timing bets and I will probably be one of them but, man, it seems like a bad bet right now. Anyway, do as I say, not as I do.

Other considerations

This post isn’t comprehensive. There are other considerations like taxes (do you have tax deferred accounts like 401ks and IRAs or just regular taxable accounts), how to allocate your equities (US or foreign; small cap vs big cap), and just your overall risk tolerance. Some people want 80 or 90% stocks. Some can only handle 40%. I think there’s also a good argument to cap gold at 10% and reallocate the 3% to managed futures or to bonds. That’s mostly just a rounding error though.

I’ll probably return to these issues in the future but until then just remember the Roys. An investment portfolio, just like a family, takes all kinds.

Keep learning,

Alan

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1  There are some nuances when you talk about stocks. Many people have primarily large US stocks like the S&P 500 index but some others might hold a Total Stock Market fund that includes a proportionate amount of foreign stocks and many will have a weight towards tech stocks with some kind of growth fund like NASDAQ’s QQQ or if you’re nuts the Arc ETF.

2  It’s still unclear who actually came up with the 60/40 allocation. It just sort of evolved. The general thought is that a younger person might better off with a 90/10 or 80/20 portfolio and a retiree might be better off with a 50/50 or 40/60 portfolio as they have less time to recover from stock drawdowns. 60/40 became the short hand somewhere in the middle.

3  Some of gold’s recent outperformance is the result of Chinese buying. With the deflation of China’s real estate bubble and the terrible performance of its stock market, it’s basically the only asset most Chinese can buy that can hold its value.

4  You can trade just about anything with futures including stocks, bonds, currencies, and commodities. I tend to like managed futures that focus mostly on commodities as they’ll tend to have the lowest correlation to stocks and bonds.

5  This is the same thing they were buying in the movie Trading Places.

6  I do hold short term Treasuries as cash. They don’t really provide the same downside protection that longer term Treasuries do.