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During the 2010-11 NBA season, 22.2% of all shot attempts were three-pointers. Last year, that figure rose to 39.2%. As the talents and abilities of players evolve, so does the nature of the game. Today, the game as we know it is faster and less dependent on the big man in the middle.
The same can be said about investing. For decades, the 60/40 portfolio split has been widely used by investors. Now, however, with record volatility in equities and federal interest rates on the horizon, that long-standing strategy is being challenged.
With an influx of alternative investment opportunities now available to investors, a new strategic approach to allocating your portfolio has emerged: the 33/33/33 allocation.
Traditional portfolio allocation (60/40)
The late John Bogle, founder of Vanguard Investment Group, popularized classic portfolio allocation and inspired many to take a simplistic approach to investing. Its traditional allocation is 60% equities to provide capital appreciation and 40% fixed income securities for stability. Through this traditional portfolio allocation, investors strive to generate returns and minimize volatility by holding stocks and bonds.
The 60/40 portfolio also has a track record of strong, double-digit returns; from 2011 to 2021, the 60/40 portfolios generated an average annual return of 11.1%. In 2021, traditional 60/40 portfolios, using Vanguard’s total market funds, returned 14.6%, including a dividend yield of 1.73%.
In addition to its long-term consistency, many proponents also cite that the diversification benefits of the 60/40 portfolio can help protect investors from risk. In fact, this strategy has historically reduced portfolio volatility and mitigated market risk over the past three decades. Between 1991 and 2021, the 60/40 portfolio had a Sharpe ratio of 0.7.
Past performance, not a future indicator
In January 2022, however, the Bloomberg 60/40 Index lost 4.2%, the biggest one-month decline for the index since the start of the pandemic. This could be proof that a traditional portfolio allocation no longer serves the best interests of investors.
The objective of diversification between equities and bonds is to minimize the overall risk of the portfolio. In the past, stock price movements did not tend to impact bond prices and vice versa. However, the correlation between these two asset classes has started to turn positive. This means that both assets could be susceptible to a hit when the markets turn, which can pose a significant risk to your portfolio.
Today, stocks are experiencing heightened volatility. Since November 2021, 40% of the 3,300 companies listed on NASDAQ have lost more than 50% of their market value. Meanwhile, Meta’s $251 billion single-day market capitalization drop on Feb. 3 was the largest single-day market value drop of any U.S. public company on record. Despite a stock market sell-off at the start of the year, many valuation metrics show the stock market to be overvalued; in early February 2022, the S&P 500 was trading at 20.4 times annual earnings. Some analysts are warning of a stock market superbubble similar to those seen during the Great Depression of 1929 and the dotcom bubble of 2000.
The geopolitical conflict between Russia and Ukraine also intensified market volatility. The NASDAQ has fallen more than 18% since its all-time high in November, while the S&P 500 is at its lowest level in nine months. The Dow has officially entered market correction territory, just eight weeks after the index hit an all-time high.
Meanwhile, mainly due to the authorities’ attempts to rein in rising inflation, the Fed plans to raise interest rates this year. These rate increases will likely put pressure on bond market prices, as fixed income securities have historically fallen when the Fed raises interest rates.
But inflation has more impact than the bond market. During periods of inflation above 2.5%, stocks and bonds have historically become even more correlated. With inflation at its highest level in 40 years, analysts are warning of further implications for both asset classes.
All this to say that the 60/40 portfolio might not make sense in today’s changing economic landscape.
Related: The investment strategy that can reduce risk in your portfolio
Looking for a new approach to investing
Who can investors turn to if 60/40 doesn’t work the way it used to? Investors have already started fleeing high yield bonds. There seems to be little incentive to switch to lower risk bonds with much lower yields. Some believe that more weight should be given to actions; others suggest foregoing asset diversification and investing 100% in broad equity indices.
In light of impending interest rate hikes, some believe cash and cash equivalents should replace bonds as a safe haven – although this strategy comes with a unique set of risks. Others believe the inability of traditional portfolios to diversify into emerging markets is leaving money on the table.
There is also a growing sense that alternative investments may deserve more attention.
Related: Innovation, Fintech, and the Future of Investing
Alternative assets are gaining momentum
First, alternatives have historically generated returns equal to, if not better than, stocks or bonds. Precious metals were the best performing asset class in 2020, while cryptocurrency and commodities led the way in 2021. From 1992 to 2020, farmland returns outperformed the S&P 500, bonds and even real estate.
Second, alternatives can act as a powerful tool for portfolio diversification. The correlation between venture capital and large cap stocks in the past was -0.06, indicating that there is no investment performance relationship between the two. Farmland historically had a negative correlation to stocks and bonds, while digitized real estate security tokens had a low correlation to the stock market of 0.15. Commodities – considered among the best inflation hedging opportunities – previously only had a 30% correlation with equities.
Third, alternative investments have always been less volatile than traditional asset classes. In fact, adding real assets to a traditional portfolio can reduce the overall standard deviation of a portfolio. As shown in the chart above, allocating just 15% of the portfolio’s assets to farmland reduced portfolio volatility by around 2%, lowering the average standard deviation to 10.53% with a portfolio 60/40 at 8.92%. The addition of real estate to farmland also reduced volatility. The 10% allocations to farmland and real estate have also historically increased returns, reduced volatility and resulted in a higher Sharpe ratio.
The case of 33/33/33
As the alternative industry becomes more accessible and transparent, evidence is emerging for a new portfolio allocation strategy: 33/33/33. A portfolio split between stocks, bonds and alternatives has historically performed well, often outperforming other allocations. Compared to a 60/40 allocation over this period, a 40/30/30 portfolio (40% equities) generated a higher annualized return with lower volatility and lower maximum drawdown.
The integration of alternative investments has also historically outperformed more defensive positions. Another study compared the performance of a portfolio consisting of 60% bonds and 40% stocks to a portfolio evenly weighted between stocks, bonds and alternatives. From 1989 to June 2021, the portfolio with alternative assets generated lower volatility and higher returns than the defensive portfolio.
The new era of allocation
Each portfolio is uniquely created to meet the objectives of each investor. Many have previously relied on traditional portfolio allocation, although there is evidence to support incorporating alternative investments into one’s portfolio. Forecasts peg global assets under management to alternatives to exceed $17 trillion by 2025. There are many opportunities to embrace the new era of asset allocation and begin integrating new investments into your wallet.
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