60/40 Is Dead: Risk Parity Isn't That Much Better Anymore Either

Feb. 22, 2020 5:06 AM ETEFAV, PIMIX, TLT, USMV, SPY51 Comments
Logan Kane profile picture
Logan Kane
20.23K Followers

Summary

  • With the 10-year Treasury yield under 1.5 percent and stocks at record highs, investors need to check their return expectations at the door.
  • The traditional 60 stock/40 bond portfolio at current valuations is no longer capable of supporting most investors' retirement and long-range liabilities.
  • Investors have three choices to achieve the returns they need - leverage, concentration, and illiquidity.
  • Low/negative government bond yields have forced European investors to make hard choices, and with the US 10-year yield under 1.5 percent, those same problems have now been imported to America.
  • Ironically, stocks are fairly cheap compared to bonds.

The default portfolio choice for investors from the 1970s onward is the 60 stock/40 bond portfolio. Back when bond yields were high and earnings multiples were lower for the S&P 500, this meant you could get returns around 9-10 percent with a level of volatility that most investors were comfortable with. Ray Dalio's Bridgewater Associates (and later other sophisticated hedge funds) found through statistical research that an even better approach was to leverage US Treasury notes so that the volatility from the bond portion of the portfolio and the stock portion of the portfolio had roughly equal volatility (Bridgewater historically earned roughly 15-18 percent returns for the same level of volatility as 60/40 portfolios, before management fees). This approach is known as risk parity and is usually combined with strategic investments in commodities and credit to balance the portfolio further.

Risk Parity: Too Good to Last

When I started writing about risk parity in late 2018, it was a no-brainer. Take positions in the S&P 500 (SPY) and 5- and 10-year Treasury notes through futures yielding over 3 percent both financed by cash at a little over 2 percent and whichever way the economy went, you would be relatively balanced and could expect a positive return. If the economy heated up, stocks would likely keep surging, and if the economy cooled off, the Fed would be likely to cut rates, creating a nice profit for the Treasury position. Both positions had positive carry, positive real yield, and positive roll-down (via earnings increases for stocks and yield rolldown for bonds). I was so excited about the idea that I took an afternoon from my vacation in Cabo San Lucas to write about the concepts, complete with hand-drawn graphs outlining the portfolio theory. For the few people who read the article

This article was written by

Logan Kane profile picture
20.23K Followers
Author and entrepreneur. My articles typically cover macroeconomic trends, portfolio strategy, value investing, and behavioral finance. I like to profit from the biases and constraints of other investors. My work is available along with 1,000+ other authors by subscribing to Seeking Alpha Premium.You can read some more of my work here on my Substack.

Disclosure: I am/we are long SPY, MUB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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