When it comes to investing, the objective for most investors is to both maintain their purchasing power (beat inflation) and ideally increase it by earning at least modest returns in excess of the inflation rate. The problem is that these investment goals are getting harder to achieve using traditional investment strategies as the impact of more than a decade of increasingly aggressive monetary policy has created an investment environment fraught with risk, persistent inflation and asset bubbles in nearly all major asset classes.
The 60/40 portfolio strategy has been the default for many investors, but it's about to get rockier in what is likely to be a low-return world in the years ahead.
The strategy is designed around the idea that stocks produce most of the returns in an investment portfolio but are very risky, by including a significant 40% allocation to bonds with their historically low correlation to stocks and lower price volatility, returns higher than inflation can be generated with just moderate levels of risk. This strategy has had an awful year so far with losses around -17%, compared with losses in the S&P 500 of -20%. Unfortunately, the road ahead does not look much better for the classic 60/40 portfolio strategy.
When Monetary Policy Goes Off the Rail
With interest rates rising, it could be time for you to rethink your portfolio.
The Federal Reserve has rapidly raised its benchmark rate to 1.75% from 0.25% through consecutive rate hikes, which are expected to continue through the end of the year. This comes after the Consumer Price Index rose 8.6% in May, signaling the highest inflation in 40 years.
Persistently high inflation will continue to strain consumers' budgets and lead to less spending, declining business earnings and likely a recession later this year.
Inflation Creates a High Hurdle
When it comes to measuring your investment performance, real returns are all that matter. Real returns are simply your portfolio’s investment returns minus the inflation rate over the same period. In other words, real returns indicate whether you have increased or decreased your purchasing power over time through your investing activities.
Historically the 60/40 portfolio has produced average annual returns around 6%, with inflation today being higher than 8%, your portfolio would need to generated returns of higher than 8% this year just to maintain the spending power of each dollar you have saved and invested. This is a high-performance hurdle to clear.
Further complicating the picture for the 60/40 is the fact the high interest rates are the primary tool the Federal Reserve has to fight inflation. Bond prices move opposite to interest rates, when interest rates go up, bond prices go down. The 40% bond allocation of a 60/40 portfolio is likely to worsen performance over the coming years and contribute little to its customary role of risk management.
When the Facts Change—Your Portfolio Should Change
Investors face the most difficult markets in decades. Investment strategies like 60/40 that have worked so well in the past are not likely to perform the same over the next decade. Investors who identify major market shifts and adapt their strategy accordingly will do the best over the long-term.
So how should investors deal with inflation, rising interest rates and declining earnings growth in stocks? The first step is to reset expectations, positive real returns will be hard to achieve in the coming years. Next, investors should focus on defense and position their portfolio to take advantage of future opportunities.
Bonds are likely to continue to decline as rates rise and stocks are also at risk of continued decline, so what is an investor to do? They should strongly consider decreasing their allocation to bonds and keep the proceeds in cash. Adding an 8% to 10% allocation to gold is also likely to decrease portfolio risk and may generate positive returns in a market where they are hard to come by.
While cash is not generally considered a good inflation hedge, considering the alternatives, focusing on reducing losses and having cash available when better opportunities to generate positive real returns arise may be the most prudent path. When the facts change your portfolio should change, even if it means deviating from the classic and comfortable 60/40.
Dan Irvine is principal at 3Summit Investment Management, a registered investment advisor serving private clients, institutional investors and investment advisors Learn more at 3summit.com.