The 60:40 Equity: Bond case is no longer fit for purpose

If we break the decisions down into their simplest constituent parts, the structuring or our investments is simpler than it might seem.

Before launching into a specific response to the question I received from a friend on optimal asset allocation, we need first to understand what savings or inheritance are for - and over what period they are likely to remain invested. The answers to this question form an essential building block. Without wishing to state the blindingly obvious, the longer cash can remain invested, the more volatility we can afford. If the assets are to finance a tax bill in six months, then of course they should remain invested in something close to cash. But if it is to fund a pension in ten years’ time, cash is a risky investment, as your investments need to keep pace with inflation if they are to retain their purchasing power.

Let us assume that the objective is to use the funds as a long-term backstop - an insurance against difficulties within your business and threats to your earning capacity. This implies the prioritisation of wealth preservation rather than a go-for-your-life dash for growth! So, if I can be presumptuous enough to work on this assumption, these assets should be invested with a prime objective of retaining their purchasing power for when they might be needed. I would trot out the standard ‘keep pace with inflation’ platitude, but of course the government’s measures of inflation tend not to reflect our actual living expenses.

So, we now have the assumed objectives and timescales required to make informed decisions about the allocation of your assets. The fund management industry is dead right on one issue - more than 90% of returns derive from the allocation of assets between categories, rather than individual share or bond selections. Where I believe it has been negligent is in sticking to the traditional historic base case allocation of a 60:40, equity: bond split. They trot out the requirement to diversify and achieve a spread of risk, but there appears to be a widespread inability to fully understand the concept of diversification. The idea of diversification is to hold assets that do not correlate with each other, and whose performances can therefore be expected to differ from one another under most foreseeable circumstances.

The 60:40 split was born of an assumption that bonds and equities always behave differently - and even move in opposite directions, displaying a negative correlation. On the face of it, if returns from bonds and equities were uncorrelated, then this measure of diversification would seem reasonable. However, this is one of many areas of investment thinking where history does not provide a reliable guide. In the simplest of terms, the theory is that when the economy overheats, equities rise and central banks are forced to raise interest rates to cool economic activity and prevent inflation. When interest rates rise, of course bond prices fall and move in the opposite direction to equities excited by improved prospects for growth.

So, what has changed that makes the 60:40 split redundant? Firstly, through the 1980s and beyond, disinflation - where the rate of inflation falls - benefited both bonds and equities and caused both asset categories to move in the same direction. Conversely, when the inflation rate increases and rates rise, this is bad for bonds, and equities can also suffer, both from the prospect of more expensive corporate borrowing, and in relation to increased income from cash when the much less volatile and seemingly safer option provides a  return that calls into question the justification to invest in more volatile risk assets - such as equities. The second is a more serious and fundamental reason. If the value of paper currencies continues to erode, the risk of holding cash and other monetary assets such as bonds increases. The purchasing power of $1 has fallen 99% since 1913, and any asset that does not address this risk provides no long-term protection and wealth preservation. As a result, two large American investment banks are rumoured to have adjusted the 60:40 ratio to 60:20:20, having split the 40% bond allocation with gold and other commodities. This is obviously a step in the right direction.

Western governments continue to run huge deficits, increasingly financed by printed currency. This is not sustainable, and the interest on America’s outstanding debt already exceeds the country’s $1 trillion annual defence spending. If central banks do not change course, more and more of our taxes will be needed to service historic debt and inflation linked state and public sector pensions, until there is nothing left for public services. France and Italy are almost there. This is why I believe that the only logic for the inclusion of cash and short dated bonds is to provide some liquidity for any unexpected (or even planned) expenses. The balance should be spread among ‘hard assets’, defined as real stuff that is likely to keep pace with living costs in the money of the day. Never forget that our paper currencies are NOT money - they are credit, as stated on each note as a ‘promise to pay’. Paper currencies are therefore easily debased by a government’s ability to print infinite numbers of these credit notes - until buyers of their debt don’t turn up to the auctions and demand higher and higher interest rates. Eventually, as has so far happened with every paper currency in history, confidence and trust evaporates entirely, and bond certificates’ only use becomes decorative. They can make attractive lampshades. Conversely, governments cannot print gold.

I have expended several paragraphs without reaching a conclusion. Using these assumptions and conclusions, diversification must be achieved between different forms of real, as opposed to monetary assets - some providing immediate income, others an historically successful hedge against currency debasement and inflation. So, rather than rely on monetary assets such as cash and bonds to provide income, there are many hard assets that not only provide yield, but also the promise of income that increases along with inflation. The overall classification of this segment would be property, but this term covers a multitude of sins. Residential housing, offices, shopping centres, warehouses, factories, hospitals, GP surgeries, motorways, renewable energy storage and infrastructure, pubs, restaurants, pleasure parks, hotels and even brothels - yes there has once been a brothel listed on the Australian stock market! The list goes on, and of course these sub-sectors are also not homogenous, performing differently to one another under different economic backgrounds. The sector itself therefore provides no 'silver bullet'.

Then there are commodities - not just precious and industrial metals, but oil and ’soft commodities,’ from beef, cattle to cotton and orange juice. Again, these are anything but homogenous and behave differently to one another - but each constitutes a real rather than monetary asset. Finally, there are some hedged funds whose returns rely exclusively on the skill of their managers, rather than the direction of the underlying markets. These can be ‘long/short’ funds that are long and short of individual equities in equal measure and derive an ‘alpha’ return that merely reflects the manager’s success in selecting winners and losers relative to their index, rather than the return from the underlying index itself.

These lists are by no means exhaustive, but I hope they provide a flavour. In terms of a logical asset allocation split, I can only offer a very approximate summary of what I do with my family’s investments. I should first explain my bias towards income that might imply a high yield requirement needed to pay the electricity bill. It is not! I find the arithmetic of compounding income compelling. Banking some return each year to be reinvested and compounded (defined as the generation of income from previously received income) also avoids a total reliance on the capital appreciation of equity investments which in the short term can swiftly evaporate. The Japanese equity index took over thirty years to recover from its peak in 1989 and provides no appreciable income yield. Many will take issue with my approach and would therefore maintain higher allocations in growth equities, but my personal allocations do include some energy and mining equities as well as ETFs within the commodity silos.
 

About the author 

Jo Welman had a career in the City spanning 45 years and worked in a wide variety of financial sectors. After graduating from Exeter University in 1979 with a degree in economics, Jo spent ten years at Baring Asset Management where he managed a range of UK and US pension funds and unit trusts, investing across multiple sectors including bonds, international equities, commercial and residential property and private equity.

In 1989 Jo became Managing Director of merchant bank Rea Brothers’ institutional and private wealth investment management division. Over the following decade Jo launched a series of specialist investment trusts and funds in a variety of industry and property sectors, before forming a joint venture with reinsurance broker Benfields (now Aon Benfield) and raising one of the first limited liability corporate capital vehicles for the Lloyds insurance market in 1993. As part of his long-standing involvement in the insurance industry, Jo co-founded the Benfield Re-Insurance Investment Trust plc (Brit) in 1995. Following the sale of Rea to Close Brothers in 1999 Jo became Chairman of Brit Insurance Holdings Plc and in 2001, in partnership with Brit and Benfields, he co- founded specialist asset management firm, EPIC Investment Partners (EPIC).

Jo continues to provide corporate finance and investment advice to entrepreneurs and private investors. He sits on the board as a non- executive director of ARK Syndicate Underwriting

“Feet up by the pool”

Jo does not receive any remuneration for his EPIC commentary. Instead, EPIC is pleased to promote the latest edition of his book “Feet up by the pool”.

Profits from sales of the book go to The Money Charity, a charity that shares Jo’s objective to help fill in some of the worrying gaps in the school curriculum. These omissions leave many young adults lacking in the financial awareness that they need to survive in a world where they will rely on their own savings if they are ever to stop working. Even if they earn the right to a full State Pension, today this amount hardly covers council tax and utility bills, and so they need to save and build up a sum of capital amounting to around twenty times their desired retirement income. A frightening number.

As Jo eloquently says, “If we can do our bit to raise awareness of the impending UK saving and pensions crisis, the exercise will have been worthwhile.”