The last month has been a particularly choppy one for markets, with the CBOE Volatility Index (VIX) spiking more than 80% during October. It’s clear the combination of rising interest rates, mounting trade tensions and looming recession fears are setting in. But what’s more unsettling is how unprepared the average client is to navigate the next market downturn.
Harry Markowitz’s modern portfolio theory, which stems from his groundbreaking research in 1952’s Portfolio Selection, has led generations to believe that a well-diversified portfolio includes a 60% allocation to stocks and a 40% allocation to bonds. This cross-section of believers includes the 10,000 baby boomer investors who turn 65 each day and need their investments to generate stable income upon retirement.
The harsh reality is that the investible universe is radically different today than it was during the 2008 crisis – let alone during the middle of the twentieth century. It is increasingly difficult for individual investors to achieve true diversification in a world where asset classes and investment styles are highly correlated. As evidence, the S&P 500 and Bloomberg Barclays US Aggregate Bond Index each fell more than a percent during the first quarter of 2018.
If stocks and bonds are moving in the same direction when the next downturn hits, it will create significant problems that have no quick fixes. Central banks are not in a position to rapidly intervene to restore investors’ confidence given their balance sheets are tapped out and interest rates remain well below historical averages. This absence of a safety net – via either accommodative monetary policy or fiscal stimulus – means the destruction of capital may be permanent when a bear market wreaks havoc.
Another issue investors face is the low-yield environment that has rendered fixed income allocations rudderless in recent years. The anemic income generated from a 40% allocation to bonds will not be nearly enough to offset equity losses during a moderate recession.
With all this context in mind, advisors should be considering how to redefine portfolio construction for their clients. This is obviously easier said than done when one considers how hard it can be to achieve true diversification without leaving returns on the table somewhere. It also complicates matters that many once-popular diversifiers, including liquid alternatives and risk parity funds, have lost some luster due to the perception of high fees and mediocre performance.
