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The author is head of asset allocation research at Goldman Sachs
Since interest rates began rising in 2022, investors are recovering from one of the biggest shocks to their portfolios – and to their belief systems around multi-asset diversification.
The rise in inflation during the Covid-19 recovery resulted in one of the largest losses for multi-asset portfolios in more than a century. But until then, simple buy-and-hold portfolios that allocated 60 percent to stocks and 40 percent to bonds had been remarkably successful for the current generation of investors. Inflation has now largely normalized. So what is the optimal portfolio for the coming decade — is it OK to just go back to 60/40?
Nobel laureate Harry Markowitz’s modern portfolio theory allows us to find the so-called “optimal portfolio” with the highest return relative to risk, while incorporating the potential for diversification. This portfolio can then be combined with cash or levied, depending on risk tolerance. In retrospect, the 60/40 portfolio did indeed produce the highest risk-adjusted returns since 1900, but over 10-year rolling investment horizons, the optimal asset mix fluctuated widely and was rarely exactly 60/40.
In fact, the optimal asset mix over the three decades leading up to the Covid-19 crisis was more like 40/60. Aided by low, anchored inflation, bonds enjoyed a strong bull market and provided diversification benefits by buffering equities during periods when investors took a “risk off” approach. But since 2022, long-term bonds have underperformed. While bond yields are now higher and close to long-term averages, interest rate volatility remains high. The yield curve on bonds of various maturities is also flat. These factors suggest little advantage over cash alone.
As a result of poor bond performance since 2022 — but also strong equity returns — the optimal portfolio has shifted to almost 100 percent equities over the past decade. Unsurprisingly, the value of long-term bonds in the portfolio remains open to debate. With greater uncertainty about inflation in the years ahead, as well as rising fiscal policy risk and higher government debt-to-GDP ratios, bonds have also become riskier.
Still, it seems unwise to hold only equities in the portfolio after the strong rally and given high equity valuations, especially in the US. Expected equity risk premia — that is, expected excess returns for stocks versus bonds — are at the low end of their historical range. This could either reflect continued inflation concerns or greater optimism about long-term growth.
We think the latter is more likely, partly because of technological revolutions like generative AI and new weight-loss drugs, but also because of the unusually high profitability of the U.S. tech sector. During previous periods of high productivity growth, such as the 20s and 50s/60s, equities also outperformed bonds over long periods.
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Potential negative trends for equities include: deglobalization, both economic and geopolitical; decarbonization, with increased risk of shocks to commodity supply and rising costs due to climate change; and demographic trends such as lower population growth, increased dependency, and income inequality.
So for the next few years, we see value in getting more balanced in multi-asset portfolios again. Broader diversification is needed to diversify structural risk. The optimal portfolio for the next decade might be one-third equities with a bias toward “growth” equities, one-third bonds, and one-third real assets.
In that portfolio, growth stocks would provide more targeted exposure to improving productivity and diversifying disruption risk. A key challenge is that stocks tend to anticipate higher productivity growth before it materializes, resulting in a valuation stretch and increased risk of overpaying. With growth stocks’ already high valuations, investors will need to be selective in their pursuit of the beneficiaries of future technological revolutions.
Bonds would offer protection in the event of stagnation with higher real yields. They currently factor in low inflation, but if price growth picks up, exposure to real assets in the optimal portfolio can help diversify risk. These include stocks with pricing power in areas such as infrastructure, real estate and commodities. So investors could put 20 percent of the portfolio in equities, on top of the growth stock investments. The rest of the real assets could go into inflation-index-linked bonds.
This journey takes us back to a portfolio of around 60/40. But the optimal portfolio for the coming decade must take into account the potential for increased productivity growth and the risk of higher and more volatile inflation. This means more targeted exposures within equities and bonds.