Much ink has been spilled over the past year about the purported death of the 60/40 portfolio, referring to a traditional portfolio of 60% large-cap public market equity and 40% core fixed income. Much of this angst arose from the increased correlation between equity and fixed income in 2022, with both asset classes losing money on the year. In our view, a primary reason why a public-only, 60/40 portfolio may no longer achieve investors’ wealth creation and retention goals is that a fundamental misunderstanding exists between capital allocation and the contribution to risk.
For example, a 60/40 portfolio has experienced 9% volatility (measured by standard deviation) over the past two decades. When we decompose the risk of that 60/40 portfolio, we find that 98% of the ups and downs are driven by the 60% allocation to core equity.
Many investors, upon seeing this, assume that decreasing the allocation to equity and increasing the allocation to fixed income is the answer. That might look like a more conservative 40% equity and 60% fixed-income portfolio, with 6% volatility. But when we decompose the risk of that more conservative 40/60 portfolio, what we find is that 88% of the ups and downs are still driven by just that 40% remaining allocation in core equity.1
Public-only portfolios may no longer deliver, due in large part to embedded outsized equity risk.1
So, we find that it does not matter if investors are more aggressive or more conservative: If they have not properly diversified the risky core equity part of their portfolios, they could still find themselves overly impacted by the volatility of the equity markets (and therefore the news flow of CNBC or Bloomberg over the preceding weeks).
We have seen many financial advisors do good work diversifying their portfolios’ company-specific risk through diversified exchange-traded funds (ETFs), manager selection and manager overlap analysis, but their portfolios are still dominated by broad equity risk. Even if an investor’s starting point is much more diversified than a traditional 60/40 or 40/60, they may still experience an equity risk overload.
Even if your starting point is much more diversified than a traditional 60/40, you may still experience equity overload.2
We believe the solution to breaking away from this paradigm can be found by looking outside of the traditional stock and bond matrix to diversify core equity risk in a different way.3 Private markets are one of those ways.
For more information on building diversified risk budgets and portfolios with private markets, please see our Private Markets Insights newsletter:4“Out with the Old and in with the New: a 50% Private Markets Portfolio.”
