2022 has been a difficult year for investors’ portfolios. Both stocks and bonds have fared poorly — defying common investing wisdom that “bonds go up when stocks go down.”
These developments spark questions about the future durability of the traditional 60/40 portfolio and highlight why investors may want to add alternative investments to the mix.
The foundation of “diversified” portfolios
The foundational 60/40 portfolio, where 60% is invested in stocks and 40% in bonds, is the initial starting point for many portfolios. The balance of this 60/40 mix then adjusts based on an investor’s time horizon, risk tolerance and financial goals, but its stock-bond combination is core to what is considered a “diversified” portfolio.
Typically, when growth assets, like stocks, sell off due to economic slowdowns, safer assets like bonds appreciate as investors seek stability. While stocks tend to suffer in a recession due to less economic growth, bonds can rally because the U.S. Federal Reserve typically cuts interest rates to support the economy. When interest rates are cut, bond yields drop but bond prices go up. This provides a shock absorber in the portfolio, helping to cushion overall returns when stocks are falling.
The 60/40 stock-bond balancing act of “diversified” portfolios has been the foundation of investing for decades.
So, why aren’t bonds diversifying stocks now? In a word, inflation. While history shows bonds hedge stock selloffs remarkably well, there are exceptions to that rule.
Past performance is not a reliable indicator of future results. Source: Bloomberg, as of March 31, 2022. Notes: The return of bonds are based on the annual return of Bloomberg U.S. Aggregate Bond Index from 1976 to 2022. Prior to 1976, the returns are based on the 10-year U.S. Treasury Bond. Stocks are represented by the S&P 500 Index from 1957 to 2022. Prior to 1957, the returns are based on the price changes in the S&P Composite Index.
What we can learn from 1969
In the mid-1960s, as prices rose, the Fed belatedly shifted into inflation-fighting mode by rapidly raising interest rates. The move eventually led to an economic recession and a period of negative returns for stocks and bonds. Bonds were able to provide a hedge to equities eventually, but only after the Fed had sufficiently snuffed out inflation.
The key lesson: Bonds may be a reliable diversifier when economic growth is slowing — but not necessarily when inflation is spiking. Why? Because when stocks decline due to rising inflation concerns, the Fed may simultaneously have to raise interest rates to slow inflation. In the end, bonds may lose out as well, potentially exacerbating losses in a diversified 60/40 portfolio.
Alternatives may no longer be alternative
During these roller-coaster market cycles, it’s important to stay invested. Hoarding cash under a mattress is not an effective solution — inflation will eventually erode its purchasing power. But “staying invested” doesn’t necessarily mean doing nothing either.
Stocks and bonds are still the bedrock of any long-term investment strategy, but inflation exposes a key vulnerability of their classic diversifying relationship. That leads to the search for solutions outside of traditional investments in the form of alternative asset classes and alternative strategies.
Alternative asset classes
Alternative asset classes cover a broad spectrum, from private equity in non-public companies that are preparing to IPO, to collectible coins and real estate.
Given the current environment, it may be wise to focus on real assets, which have a history and sound fundamental basis for weathering periods of inflation. While stocks and bonds are financial assets that represent ownership of a company or its debt, real assets are physical assets that themselves have an intrinsic worth.
- Commodities: Historically have done well in inflationary markets, as they are commonly linked to an underlying source of inflation (e.g., precious metals, oil, and corn).
- Real estate: Should benefit from inflation because an overheating economy typically results in rising home prices and/or rents.
- Real estate investment trusts (“REITs”): Publicly traded like a stock but have ownership in real estate across a range of property sectors like single-family homes, apartments, offices, and other commercial buildings.
However, one must consider the impact of current valuations in the assessment of any potential asset class to provide an inflation hedge. Actual inflation that turns out to be less than the inflation embedded in those prices can lead to a loss of value.
Alternative strategies are made up of traditional asset classes like stocks and bonds but invested in non-traditional ways, similar to hedge funds. Like alternative assets, alternative strategies vary. They can employ sophisticated techniques like long/short investing, options trading, trend-following, or multi-strategies that do a bit of everything.
Alternative strategies specifically designed to diversify portfolios can both help to cushion equity sell-offs and may boost flagging portfolio returns. These types of strategies seek to have low (to zero) sensitivity to the ups and downs of the market because they aren’t impacted by the same underlying factors that drive stocks or bonds. They don’t always go up when stocks and bonds are down, but their overall low and/or uncorrelated returns can help create more consistency in a portfolio’s outcomes — exactly what the 60/40 is missing today.
Rethinking the 60/40 portfolio
Inflation poses a challenge to the traditional stock-bond portfolio that we haven’t seen since the 1970s. The diversifying nature of the relationship is under increasing pressure, making rethinking portfolios more critical than ever.
Alternative asset classes, like real assets, may be able to provide a hedge against rising inflation. Alternative strategies specifically designed to diversify may help offset equity market declines and lift lackluster bond returns.
Wondering about alternative investments?
If you’d like to revisit your portfolio’s makeup, it’s time to schedule a review with your Ameriprise financial advisor. They will recommend an asset allocation strategy that is unique to your circumstances and can make any adjustments as your risk tolerance, time horizon and financial goals evolve.