The Popularity of 60/40 Portfolios By Dr. Edward Qian, PhD CFA, Chief Investment Officer and Head of Research, Macro Strategies, PanAgora AssetManagement
MANY plan sponsors allocate their pension assets to a portfolio
of 60/40 global stocks and bonds. More sophisticated plans use
variations of a 60/40 portfolio, as they substitute private equity, real
estate and other hard assets, or hedge funds in place of public equity
or fixed income exposure.
Why do these plan sponsors (and their consultants) design a policy
portfolio with that target in mind? Asset allocation is by far the most
important investment decision for many investors. Each year, plan
sponsors devote a significant amount of consideration and resources
to traditional asset allocation studies, starting from asset return
forecasts and risk estimation, followed by portfolio construction
with a combination of quantitative methods and qualitative tilts. Yet,
irrespective of investment environment changes over time, it seems
that the popularity of 60/40 portfolios continues to persist. Why?
We offer a potentially simple explanation. In order to achieve a
targeted nominal return, based on a reasonable set of capital market
assumptions and budget constraints, one only has to have sufficient
investments in stocks and other risky assets. Hypothetically, if the
return target is 8%, and if the expected return for stocks is 10%
(higher than 8%) and the expected return for bonds is 5% (lower
than 8%), a 60/40 portfolio would meet the target with an annualized
standard deviation of 10% and anything else with less exposure to
stocks would not yield 8%.
Is there anything wrong with a 60/40 portfolio then? Why is the
ubiquitous 60/40 widely known as a balanced portfolio? Millions of
investors clamor for balanced funds. If it is labeled balanced, it must
be diversified, and based on its 60/40 capital allocation it is just that.
But what’s in a name?
The Unbalanced Portfolio
The truth is 60/40 portfolios are not balanced at all. A lot has gone
wrong for 60/40 portfolios. As global financial markets roiled by
the technology bubble burst in 2000 and the latest credit crisis in
2007, 60/40 portfolios and their more sophisticated cousins suffered
tremendous losses due to their exposure to risky assets. The bond
portion of the portfolios proved to be inadequate in providing any
meaningful diversification and downside protection. The balanced
portfolio has stumbled, repeatedly. What’s the underlying cause of
the failure of 60/40 portfolios?
To anyone who has researched the risk allocation of 60/40
portfolios and its return implications, what happened should not
be all that surprising. The fact is a 60/40 portfolio does not offer
true diversification because 95% of its risk profile is from equity or
equity-like risky assets while the remaining assets contribute only
5% to the risk profile. In a 2005 research paper, we used a simple
example of “eggs” to illustrate the concept of risk allocation1. In
essence stocks are considerably more risky than bonds, so a 60%
allocation to stocks leads to a highly concentrated risk allocation.
The balanced fund is truly unbalanced.
The unbalanced risk allocation has many consequences. For
example, the return correlation between a 60/40 portfolio and stocks
is close to 0.98. But by far, the strongest financial implication of risk
contribution is loss contribution.
From Risk Contribution to Loss Contribution
Why should we care about risk contribution? We should, and must,
because it is a measure of true diversification and it has a direct and
measurable connection to portfolio return stability. Not long ago,
many investors and even some prominent researchers doubted the
usefulness of risk contribution because the concept seemed to be of
a mathematical nature, with no apparent financial interpretation.
In a separate academic paper2, we provided such an interpretation
that firmly established the connection between the concept of risk
contribution and portfolio returns. We found that risk contribution
is a very accurate indicator of loss contribution. This is especially
true during times of financial stress. In other words, when a 60/40
portfolio suffers a large loss, we can blame almost all of it (on average
95% and often much more) on stocks.
A simple empirical example sufficiently illustrates this linkage.
Take a “traditional” 60/40 portfolio consisting of the S&P 500
Index and the Barclays Capital Aggregate Bond Index. Using the
monthly returns from 1976 to 2009 and a loss of 3% as threshold,
there are thirty-two months when returns of the 60/40 portfolio
suffer a loss greater than 3%. From the thirty-two data points, the
average contribution to the portfolio loss is 97% for stocks and
3% for bonds. Just as our research proved, the risk contribution
accurately predicted the loss contribution. When this approach is
applied to a global equity and global bond benchmark (like MSCI
World Equity Index and Barclays World Global Bond Index) a
similar relationship exists.
Stocks also have fat tail risk and negative skewness. Using Value
at Risk as a risk measure, we have shown that the risk contribution
from stocks is even higher than it would be if standard deviation was
used as the risk measure. This is why a 60/40 portfolio is not a well-diversified portfolio. To put it differently, the diversification effect of
bonds is insignificant in a 60/40 portfolio. As a result, any large loss
generated by stock allocation will result in a loss of similar size for
the whole portfolio. This is hardly diversification.
The recent market events have provided further validation of the
downside risk present in a 60/40 portfolio. Since July 2007, the 60/40
portfolio has returned - 21.6%, with the stock portion contributing
- 23.6%, a contribution of 110%!
Risk Parity Solution
Can we use these insights to design a portfolio that limits the impact
of large losses from individual components? Years ago, it occurred
to me that one should combine the concept of risk contribution
and the principle of diversification in constructing asset allocation
portfolios. The idea was introduced in Qian3 (2005) and it led to
the creation of Risk Parity Portfolios, where we allocate an equal
amount of risk to stocks and bonds in order to capture long-term risk
premium embedded within various assets. In subsequent years, other