Future Focus: The biggest asset manager in the world thinks you won’t achieve your goals.
Returns and diversification aren’t going to be what they’ve been in the past. Here’s what investors can do.
Asset management behemoth Blackrock has declared that the 60% share/40% bond portfolio should be rethought. Morningstar’s Investment Management team agree. Their research shows that the expected returns for the next few decades won’t look like the stellar run that we’ve experienced since the GFC, and investors should temper their expectations.
According to BlackRock’s capital market assumptions, even a global 70/30 portfolio is expected to achieve 6.5% annually. Alongside the lower relative return, they believe that the 60/40 and 70/30 portfolio no longer works from a diversification perspective either.
In recent years, the classic 60/40 portfolio has had the two asset classes become more correlated. The reason for the portfolio split between these assets was based on the asset classes performing differently in different types of environments. This provides diversification benefits for investors. We’ve seen stocks and bonds decrease in tandem. This makes the portfolio less resilient. It leaves investors exposed, especially during periods of severe market volatility.
The figure shown relates to past performance. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. Source: BlackRock with data from Refinitiv Datastream, MSCI, and Morningstar Direct as of 30 September 2024. Agg refers to the Bloomberg US Aggregate Bond Index. Past performance is not a guarantee of future results. Indexes are unmanaged, are used for illustrative purposes only and are not intended to be indicative of any fund’s performance. It is not possible to invest directly in an index.
This leaves investors in a worst-case scenario – returns are lower and portfolios are more volatile.
If not the 60/40 portfolio what should an investor do? This is an extremely important question. It could mean the difference between achieving your financial goals – or not.
Why should I pay attention?
According to Ibbotson and Kaplan’s research, asset allocation is responsible for 100% of your returns. It is more important than your security selection where many investors place emphasis. Understanding the mix of aggressive and defensive assets required to achieve a certain return allows investors to plan.
Diving deeper into the house view, Blackrock’s CEO Larry Fink focuses less on the investment growth and more on the diversification. He believes that the 60/40 portfolio from the 1950s is outdated as the investment industry has evolved. Fink suggests that a diversified portfolio may be more like 60/20/20 – incorporating asset classes from private markets into a portfolio that will provide better diversification.
It’s not my job to pontificate on whether Blackrock or Morningstar Investment Management are right. There are men and women much smarter than me that spend their days developing capital market assumptions that go into this model. As an individual investor, you must make decisions based on the data available to you. You should be asking yourself a couple of questions:
- Do I think that the recent return levels are sustainable?
Over the life of the share market, we’ve experienced a bear market every three years, on average. We have not experienced a bear market since 2008. In my opinion, it is inevitable that we’re going to have some rougher periods that will drag down the aggregate. The lessons we can learn from share market history is that we are going to experience lower returns at some point.
- Do I want to do increase the possibility of reaching my financial goals?
Valuations are stretched. Across equity markets, valuations are high which historically has left less room for future growth and lowered returns.
There’s not much that investors can do about market returns. However, there are a few levers that they can pull to maximise the chances that their portfolio will meet their goals. Below, I discuss these levers.
Asset allocation
Asset allocation is the primary driver of your returns. Taking on a more aggressive allocation will increase your expected return, but it will likely introduce more volatility into your portfolio. This is a balance that needs to be carefully managed, especially for those that do not have long left in their time horizon.
Asset allocation does not need to always include an equities/bond only split. This is Fink’s view, where he believes that alternatives deserve a place in investors’ portfolios.
Within the high-level equity/bond categories there are many variations with different risk and return characteristics. For example, a higher allocation to corporate bonds over government bonds in a bond allocation. Or, speculative small caps over mature, dividend paying large caps.
The Bucket Portfolio method could be a solution to deal with lower expected returns for those in retirement. It involves taking on a higher degree of aggressive assets which should do well over the long-term, but structuring your portfolio in a way that means you will be able to meet short-term income needs.
The Bucket Portfolio method allows an investor to stay invested in aggressive assets for a longer time frame. Buckets 3 can be filled with aggressive assets, Bucket 2 is filled with income producing assets, and Bucket 1 is filled with cash. Bucket 3 refills Bucket 2, Bucket 2 refills Bucket 1. This structure provides diversification, income and also increases the amount of aggressive assets you can hold.
You can read more about the Bucket Portfolio method here.
Contributions
Want a higher chance of reaching your goals? Contribute more. This is one of the only levers that you completely control. This is central to my investment strategy. I maximise my contributions to increase the chance to get to my goals quicker. I am increasing my chance of getting to my financial goals.
Time horizon
Lastly, let time work its magic. If you have the capacity to stretch the time horizon of your goal, you have a longer time to contribute to it, and a longer time for your investment growth and earnings to compound.
An example that I like to show comes from our Investment Management team. They’ve put together a model that explains how much you’d have to save to have $1 million by 65.
Source: Morningstar Investment Management. About the data: The image represents the monthly savings necessary should the investor earn 7% per annum from a hypothetical asset. No adjustment has been made to account for inflation, fees, transaction costs, or taxes.
The graph on the left looks at the dollar amount needed at different ages. As you can see, it is not a linear progression. The older you are when you start investing, the more you need to save to reach the same end goal. This is explained by the graph on the right, which shows the split between capital (the amount you invest) and growth (the gains you make from investing). The more time that you have, the more time your investments have to compound.
If market returns are lower and you are unable to contribute more to your goal, extending your time horizon may be a good option. A longer time horizon also allows you to invest in more aggressive assets, for longer.
Final Thoughts
Equity markets are one of the best ways to grow our wealth and achieve our financial goals. Unfortunately, the market isn’t always going to be in our favour. Markets have had a good run. Be wary of projecting this into the future.
Parallel to this, the correlation between asset classes has shifted recently. The impact on diversification needs to be reassessed. That doesn’t mean that new asset classes are the answer. The bucket portfolio method provides a promising structure that manages volatility, offers investors the opportunity to hold aggressive assets over a longer time frame.
What is important to me is ensuring that I am maximising the success of my portfolio through measures that I can control. I am ensuring that I maximise my contributions right now so they can compound over longer time frames.
My asset allocation is aggressive because I take a long-term view. My portfolio isn’t linked to financial goals that are being realised within the next 10 years which means I do not need assets that temper volatility.
I carefully consider costs in my portfolio, so they do not mute whatever returns occur in the share market. Focus on the measures that you can control. This will work well in every situation.
Invest Your Way
For the past five years, Mark and I have released a weekly podcast and written on morningstar.com.au to arm you with the tools to invest successfully. We’ve always strived to provide independent, thoughtful analysis, backed by the work of hundreds of researchers and professionals at Morningstar.
We’ve shared our journeys with you, and you’ve shared back. We’ve listened to what you’re after and created a companion for your investing journey – Invest Your Way. Invest Your Way is a book that focuses on the investor, instead of the investments. It is a guide to successful investing, with actionable insights and practical applications.
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