Thomas Becket: Asset Allocation – What do we really mean by Balanced?

The story begins in 1952, when an unknown twenty-five year old, Harry Markowitz, published a 14-page article entitled ‘Portfolio Selection’. After a great deal of algebra, a short analogy summarises his findings in layman’s terms, “A portfolio with sixty different railway securities, for example, would not be as well diversified as the same size portfolio with some railroad, some public utility, mining, various sort of manufacturing, etc.” To the modern investor this seems blindingly obvious, but at the time the work was ground-breaking. As the theory spread through Wall Street and continued to develop amongst academics, a new rule of thumb was born. A portfolio comprising of 60% equities and 40% bonds provided sufficient diversification to make reasonable returns when markets were strong and provide adequate protection when things took a turn for the worse. This became the first ‘Balanced’ portfolio.

In the subsequent fifty years or so, the portfolio would have served you very well. Even during the great financial crisis, a UK-focused 60/40 portfolio would have only lost 17%*, a not entirely disastrous outcome given the FTSE All Share fell over 45% peak to trough. However, if those investors were able to grit their teeth for another twelve months, they would have seen their portfolio recover and actually make 5% during what was the worst downturn in over seventy-five years. So does this, therefore, mean that a 60/40 portfolio is balanced one? I would argue that this may have been the case historically but not today. The great financial crisis and the subsequent actions taken by policymakers around the globe have shaken up the theory somewhat. When the FTSE All Share peaked in March 2007, the yield on a ten-year gilt was 5.48%. Today, after an unparalleled monetary policy experiment, you get a meagre yield of just 1.00%. Even in a world where negative bond yields have become commonplace, if equity markets were to fall 45% like they did during the global financial crisis, the yield on a 10 year gilt would need to drop to around -1.50% to offer the same protection as it did a decade ago.

So, I hear you say, what should a balanced portfolio look like today? It's easy to believe you have a balanced portfolio after a period of time when all asset classes have simultaneously risen and economic headwinds are brushed aside by the ever generous central bankers. We are now approaching ten years since the financial crisis and a lot has changed in that time, can we rest on our laurels and assume that what worked then will work today? Going back to Markowitz's analogy, have markets become so distorted that both bonds and equities have become the modern day railroad securities? Maybe I am wrong, but my thoughts are that a simple 60/40 is no longer enough.

When surveying the wealth management industry, firms proudly show off their flagship ‘Balanced’ strategy, but it doesn’t take too much scratching of the surface to realise that the simple use of an adjective leaves significant room for interpretation. Our balanced portfolio currently has 43.5% in equities, some of our peers have over 68.0%. Quite a divergence. Back in 2012, the Investment Management Association (IMA) scrapped the use of risk adjectives such as balanced amid concerns over their ambiguity. They replaced the “IMA Balanced Managed Sector” with a new “Mixed Investment 40-85% Shares”, straddling the 60% equity that had become the norm but keeping plenty of scope for interpretation. Now, if we take my earlier 60/40 example during the great financial crisis and adjust the weightings to the extremities of the IMA allowances, and simulate again over the same time period, we end up with a performance range of -3% to -35%. Admittedly, I am pushing to the fringes of what is possible within this remit, but my point is that understanding exactly how your portfolio is positioned is crucial, and just accepting ‘Balanced’ at face value is a fool’s game. This confusion doesn’t stop at balanced either. A look at our peers finds everything from ‘Cautious Growth’ to ‘Moderately Adventurous’. We are even guilty of an 'Aggressive Growth' strategy. How can any investor truly understand and compare the level of risk they are taking on from a couple of sporadic adjectives? A prudent investor needs to dig past these monikers and see what’s under the bonnet.

Thomas Becket is chief investment officer at Psigma Investment Management