Setting ourselves up for despair
Getting Modern Portfolio Theory wrong and voting Republican won't actually kill you
Photo by Konstantin Evdokimov on Unsplash
Hello,
Welcome to Known Unknowns, a newsletter where managing risk means accepting that correlations flip, but you can live in whatever state you want.
Why the 60/40 portfolio will fail in every market
Look, I am not a fan of one-size-fits-all investment strategies. Individual risk tolerance and circumstances are just too idiosyncratic. But I am starting to think many of the recent criticisms (and the ones before that) of the 60/40 portfolio are unfair. Apparently, it is failing because the bond portfolio is down, and it is no longer positively correlated with stocks. Well, yeah. That’s what happens when markets get weird — correlations flip.
The real problem with 60/40 is that what it is meant to achieve is so poorly specified to start with. I’ve tried to research its history, and legend has it that Harry Markowitz recommended it when he published his dissertation. I did not find any evidence that is true; if anyone can find proof, please let me know. However, he did prove that diversification is valuable and should be the foundation of portfolio management. I think that is the source of the confusion because the purpose of 60/40 is (I think) diversification. But is it?
First, all or most of the 60 in the 60/40 (the equity part) is invested (at least in larger funds) in US equities, and overwhelmingly in a few big tech stocks. This explains why these funds had a good 15 years. But that is not diversification. If the goal is diversification, it should be in the global equity portfolio.
The 40 part is even more of a hot mess. I am not sure what its purpose is either. If you read the literature, it is a hodgepodge of hedging and diversification. But these things are different. Hedging is taking less risk (giving up the upside) to reduce the downside, which means investing in short-term bonds (if the risk is not losing money in any given month or year). Diversification involves finding the best combination of assets, so you get the highest possible return for a given amount of risk. The difference may sound subtle, but it is very important because diversification would mean different bonds (and many of them).
Really, it seems 60/40 has just become something that chases trends with no real appreciation of risk management. The S&P 500 outperformed because of a few big stocks, and that became the equity strategy. Meanwhile, rates went to zero for a long while, so the fixed-income strategy added more duration coporates. But this all seems to violate the modern portfolio theory that where there is a well-defined risk-free asset, it is balanced with return, and an understanding that correlations are not always stable, so more diversification is better.
Despite all these issues, I see value in the idea of a standard, simple well-diversified portfolio that balances risk and reward. The problem is bad execution and a misunderstanding of risk management. I think we can have smarter portfolios that are also easier to use. But if we do stick to 60/40, it could be much better and better thought out. The reason why it is labeled a failure in every market is no one knows what it is trying to achieve.
Are Republicans to blame for early deaths?
The United States is the richest country in the world. And yet it also has, among rich countries, a lower life expectancy. Worse, life expectancy has fallen in recent years, and the US appears to have lost more years from Covid compared to other rich countries. There are many reasons why: the opioid/fentanyl epidemic, and health problems connected to a higher rate of obesity. These are hard problems that don’t have simple solutions. And yet, there is an odd argument that it is all Republicans’ fault. Economists Anne Case and Angus Deaton even suggested that if we just had stronger unions and higher minimum wages, people would live longer.
Now it is true that some things are associated with a shorter life: not getting a Covid vaccine, being around guns, and not wearing a seat belt are more prevalent in Red States — in part because they tend to be less paternalistic. But economic solutions won’t necessarily make this better. Increasing the cost of labor tends to push the least educated out of the labor force. This is also the population most in danger of drug addiction and poor health. It is unclear whether opioid use causes non-employment or is a result of it. I suspect it could be some of both.
But in any case, making it a partisan issue does not solve the problem, it only makes solutions more difficult.
In other news
JR Scott’s great job market paper gives some insight into the world we now live in.
Until next time, Pension Geeks!
Allison
The history of the 60/40 fund goes back a century to mutual funds like Wellington with a roughly 60/40 equity/bond split to provide "long-term capital appreciation and moderate current income". I think there is a lot of confusion about 60/40 portfolios, because they are really focused on people and institutions with the need to provide long-term income and not for a 25 year old looking to building wealth without withdrawals over the next 40 years. So they get compared unfavorably to "just invest in the S&P 500" for long-term total returns which is an inappropriate comparison.
The math behind 60/40 keeps being demonstrated when people analyze portfolios for long-term sustained withdrawals for periods of 30+ years. These analyses show that 30/70 to 70/30 equity/bond ratios provide much better long-term outcomes than all stock or all bond portfolios. Bengen's original 1994 paper looked at 0%, 25%, 50%, 75% and 100% equity percentages and the 50% and 75% ratios performed best for sustained inflation-adjusted withdrawals over 30 year time frames. Morningstar recently did a detailed update looking at current market valuations and found that the 30/70 to 70/30 portfolios are still expected to provide better outcomes for providing long-term inflation-adjusted income than all bond or all stock portfolios.
Bengen's 1994 work was done just on S&P 500/intermediate T-bonds but since then Bengen, Morningstar, and others have analyzed broader portfolio compositions and they keep coming up with the same general conclusion of about 3% to 5% annual inflation adjusted withdrawals are sustainable under just about all expected market conditions over 30+ years time frames for 30/70 to 70/30 portfolios, for which "60/40" or "balanced fund" is effectively shorthand to describe that portfolio type.
The much maligned target date retirement funds follow these concepts by starting at 90% equity allocations until people are in their mid to late 40s and then follow a glide path for the equity allocation until it typically hits 20% -30% after age 70 or 80. They are usually about 50/50 at age 65. I think the financial community is adamantly opposed to TD funds because they have effectively solved for many of the small investor's financial ignorance and behavioral challenges eliminating substantial fees for the financial professionals.
Voting republican may not kill you, but republican (red) states are the poorest and least healthy in the US. Bad health tends to kill you sooner.