Is The Traditional Portfolio Headed For A “Lost Decade”?

Is The Traditional Portfolio Headed For A “Lost Decade”?
Reda Farran, CFA

almost 2 years ago3 mins

  • Increasing stagflation risks combined with elevated valuations have increased the risk of a lost decade for 60/40 portfolios – that is, a prolonged period of poor real returns.

  • Real assets – like commodities, real estate, and infrastructure – have historically provided better risk-adjusted real returns during lost decades for 60/40 portfolios.

  • You can easily add real assets exposure to a 60/40 portfolio using the FlexShares Real Assets Allocation Index Fund or VanEck Inflation Allocation ETF.

Increasing stagflation risks combined with elevated valuations have increased the risk of a lost decade for 60/40 portfolios – that is, a prolonged period of poor real returns.

Real assets – like commodities, real estate, and infrastructure – have historically provided better risk-adjusted real returns during lost decades for 60/40 portfolios.

You can easily add real assets exposure to a 60/40 portfolio using the FlexShares Real Assets Allocation Index Fund or VanEck Inflation Allocation ETF.

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With the outlook for both stocks and bonds looking bleak, Goldman Sachs has sounded the alarm over a “lost decade” for the classic 60/40 investment strategy – with its balance of 60% in stocks and 40% in bonds. However, there are other ways to diversify and profit even when the good ol’ reliable portfolio begins to falter. Here’s how.

First: Why’s the outlook so poor for the 60/40 portfolio?

Ongoing supply chain issues coupled with soaring commodity prices have led to fears that we’re on the verge of a new era of stagflation – that is, low economic growth and high inflation. This combination simultaneously undermines the prices of stocks and bonds, draining the 60/40 portfolio of its diversification mojo. No wonder then the 60/40 strategy just experienced its first quarterly loss since the start of the pandemic.

Compounding the problem these days is that, despite recent pullbacks, stocks and bonds are still trading at very high valuation levels.

Financial firm JonesTrading came up with an interesting way of measuring this, adding together the S&P 500's earnings yield – the reciprocal of the more widely followed price-to-earnings ratio – and the yield offered by 10-year Treasuries. The lower the combined yield, the more expensive stocks and bonds are.

The combined yield stands at 7.2% today, and that’s bad for two reasons. First, that’s lower than it’s been for 93% of the time since data began in 1962. Put differently, that means stocks and bonds, combined, are extremely expensive relative to history. Second, it’s the first time in six decades that the combined asset yields have sat below the inflation rate.

The combined stocks and bonds yield is very low relative to history and is below the inflation rate. Source: Bloomberg
The combined stocks and bonds yield is very low relative to history and is below the inflation rate. Source: Bloomberg

Right now, we’re seeing increasing stagflation risks and elevated valuations, and that’s raising worries about a prolonged period of poor real returns (i.e. returns after inflation) for the 60/40 – the so-called lost decade scenario. It doesn’t help that history sets a bad precedent: lost decades in 60/40 portfolios are more common than investors might think. In fact, the strongest bull markets for US 60/40 portfolios, which often ended with elevated valuations, were usually followed by lost decades.

Lost decades for US 60/40 portfolios have been relatively frequent and often followed strong bull markets. Source: Goldman Sachs
Lost decades for US 60/40 portfolios have been relatively frequent and often followed strong bull markets. Source: Goldman Sachs

How can you improve on the 60/40 portfolio?

Goldman has one potential answer to that question. They’ve looked at assets that have historically provided better risk-adjusted real returns during lost decades for 60/40 portfolios, and real assets – any investment you can touch, like commodities, natural resources, real estate, and infrastructure – stood out. During periods of high inflation, real assets can offer both the opportunity for uncorrelated returns and the potential for competitive real returns. That’s because they offer inflation protection and are resilient to rising interest rates. What’s more, they look a lot cheaper than stocks and bonds right now.

Real assets have outperformed the 60/40 portfolio during periods of high and rising inflation. Source: Goldman Sachs
Real assets have outperformed the 60/40 portfolio during periods of high and rising inflation. Source: Goldman Sachs

Finimize analyst Stéphane has a few ideas – and further analysis – about how to invest in different real asset sectors. But if you want to avoid the headache of selecting specific real assets sectors altogether, the FlexShares Real Assets Allocation Index Fund (ticker: ASET, expense ratio: 0.57%) might be for you. It gives you access to real estate, infrastructure, and natural resources for a relatively low fee. An even more comprehensive (but slightly more expensive) option is the VanEck Inflation Allocation ETF (ticker: RAAX, expense ratio: 0.74%), which also includes commodities.

How much should you allocate to real assets?

There’s no single right answer here, but something between 10%-20% probably makes sense. If allocating 20% to real assets, for example, in a 60/40 portfolio, then you’d reduce the stocks and bonds weights by 20% respectively. So you’d end up with a portfolio that’s 48% invested in stocks, 32% invested in bonds, and 20% invested in real assets. I’ve back-tested such a portfolio in the US, and it would’ve outperformed a typical 60/40 strategy by 4.2% over the past year. But that’s to say nothing of its potential future outperformance if the typical 60/40 strategy is really headed for a lost decade.

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