The largest asset manager in the world, Blackrock has declared that the 60/40 portfolio should be rethought. They also believe that a 70/30 portfolio is likely to deliver 6.5% going forward. Mark and Shani take a look at the research, and what investors can realistically do to still achieve their financial goals.

You can find the full article here.

You can find the transcript for the episode below:

Shani Jayamanne: For the past five years, we’ve released a weekly podcast 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.

Mark LaMonica: We’ve shared our journeys, 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’s a guide to successful investing with actionable insights and practical applications.

Jayamanne: You’re able to pre-order the book through the links in the episode description.

LaMonica: Thank you for your continued support and we look forward to helping you invest your way.

Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situations, circumstances or needs.

So, we’re recording three podcasts today, Mark, because you’re going away.

LaMonica: I am going away.

Jayamanne: Where are you going?

LaMonica: I’m going to the US.

Jayamanne: I feel like you were just in the US.

LaMonica: Yes, it’s been two whole weeks. So, you know, excited to get on that flight again, because unlike you, I fly economy. So those flights are a little more difficult for me. But I’m not flying United this time.

Jayamanne: Okay, because they barely feed you on those flights.

LaMonica: And the AFR actually wrote an article about how terrible it is. So, I don’t have to bring 15 Cliff Bars to try to survive the flight.

Jayamanne: You couldn’t think of something more appetizing than a Cliff Bar?

LaMonica: Well, to be fair, my wife bought them.

Jayamanne: Okay.

LaMonica: So, it was all that I had, but it was more appetizing than the food that United serves.

Jayamanne: So, today we’re going to speak about the future.

LaMonica: That sounds kind of ominous.

Jayamanne: Well, it is a little. Maybe ominous isn’t the right word, but we’re going to explore what investors can do when future returns don’t look as promising as the returns we’ve received in the recent past. And the future is a hard thing to predict. But what we do have is guidance and forecasts. The largest asset manager in the world, BlackRock, has declared that the 60% share and 40% bond portfolio does need to be revisited. They don’t think it is as relevant in today’s investing environment as it was when it’s formed, with more asset classes available for investment with differing risk and return profiles.

LaMonica: And our colleagues at Morningstar Investment Management agree but based on other grounds. So, they believe that expected returns for the next few decades won’t look like the stellar run that we’ve experienced since the GFC and that investors should temper their expectations.

Jayamanne: And BlackRock is on the same page here. It isn’t just that the asset classes need to shift. According to BlackRock’s capital market assumptions, even a global 70-30 portfolio is expected to achieve 6.5% annually. Alongside with that lower relative return, they do believe that the 60-40 and 70-30 portfolio no longer work from a diversification perspective either. So just broken.

LaMonica: Broken.

Jayamanne: Yes.

LaMonica: Well, what we’ve seen in recent years, and I think this is part of what BlackRock is saying, is that in the classic 60-40 portfolio, 60% shares, 40% bonds, that those two asset classes have become more correlated. So, to understand the impact of this, let’s talk about the reason for the two asset classes and that 60-40 split in the first place.

Jayamanne: The reason for the portfolio split between these assets was based on the asset classes performing differently in different types of environments. And what this does is it provides diversification benefits for investors. We’ve seen stocks and bonds decrease in tandem, and this makes the portfolios less resilient. So, it leaves investors exposed, especially during periods of severe market volatility.

LaMonica: Now, you wrote an article on this, Shani. And in the article, you had graphs and other supporting images from BlackRock and these capital market assumptions that you’ve talked about. So, people should definitely read your article. But one of the images visually shows that stocks and bonds have moved together when inflation is above target. So, stocks and bonds are less diversifying in a high inflation environment, and that’s what we’ve really experienced since COVID.

Jayamanne: So, I guess the question is now, if the 60-40 portfolio isn’t doing the job it was supposed to, what should an investor do?

LaMonica: And this is an important question to ask. It could mean the difference between achieving your financial goals or not achieving them. And understanding how your portfolio is diversified or the expected returns, what it might mean for you and what you might have to delay in order to reach your financial goals.

Jayamanne: And research does back this. It’s important that you’re paying attention because according to Ibbotson and Kaplan’s research, asset allocation is responsible for 100% of your returns. It’s more important than your security selection where a lot of investors like to focus. So, understanding your mix of aggressive and defensive assets required to achieve a certain return allows you to plan.

LaMonica: And to understand a little more about where we move from here, we can dive a little deeper into BlackRock’s thinking. So, their CEO, Larry Fink, who I’m sure listens to the show.

Jayamanne: Hi, Larry.

LaMonica: Hello, Larry. Thank you for your support. So, he focuses less on the issue of forecasted investment growth and more on that diversification side. He thinks that the 60-40 portfolio from the 1950s is outdated as the investment industry has evolved. So, Fink suggests that a diversified portfolio may be more 60-20-20. So, incorporating asset classes from private markets into a portfolio that will provide better diversification.

Jayamanne: And this is just his opinion. It doesn’t mean that you need to follow it. And although this is an investing podcast, both of us are not experts in capital market assumptions models. We’re not going to pontificate on whether BlackRock and our colleagues at Morningstar Investment Management have considered all the assumptions and variables and decide whether they are right or wrong. There’s men and women that are much smarter than both of us that spend their days developing these models.

LaMonica: What we will do as individual investors is we will encourage everyone to ask yourselves a few questions about whether this research is important to you and what it means for your portfolios. So, Shani, you wrote this article. So, you are now the expert on this. What are some of the questions you think investors should be asking themselves?

Jayamanne: All right. So, the first question is whether you think the recent return levels are sustainable. And I think answering this question requires some context. 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 to go through some rougher periods that will drag down the aggregate. And the lessons that we can learn from share market history is that we’re going to experience lower returns at some point.

The second question is, do I want to increase the possibility of reaching my financial goals? Valuations are stretched and across equity markets, valuations are high, which historically has left less room for future growth and lowered returns.

LaMonica: And one thing just to correct you, you said we haven’t had a bear market since 2008, a real bear market.

Jayamanne: A real bear market.

LaMonica: So, we’re not counting whatever that month-and-a-half was in COVID.

Jayamanne: Yes.

LaMonica: So, that’s obviously just our opinion. I guess you can count that as a bear market, but it bounced back very quickly. So, the important thing is what do investors do about this? So, there’s not much that, of course, an investor can do about market returns. But there are other levers that investors can pull to maximize the chances that your portfolio will meet your goals.

Jayamanne: And we talk about these levers a lot. They’re the variables that go into a financial goal. So, let’s go through them. Mark, if you want to start with the first one.

LaMonica: The first is asset allocation. And this is the primary driver of returns. Taking on a more aggressive allocation will increase your expected return, but it will also likely introduce more volatility into your portfolio. And your job as an investor is carefully managing that balance, especially for investors that don’t have long left on their time horizon.

Jayamanne: And many of us as investors have deviated from this already, but portfolios don’t need to be just equities and bonds. We’ve said before that Fink’s view, the CEO of BlackRock, and he thinks that alternatives deserve a place in investors’ portfolios. So that’s one option, changing the assets in your portfolio to achieve a different risk and return profile.

LaMonica: The second approach is looking another level down into the high-level equity bond categories. There’s lots of variations with different risk and reward characteristics. For example, a higher allocation to corporate bonds over government bonds in that bond allocation. Or speculative small caps over mature dividend-paying large caps.

Jayamanne: Another approach to deal specifically with lower expected returns in retirement is the bucket portfolio method. And we speak about this a bit in the podcast. And this approach involves taking on a high degree of aggressive assets, which should do well over the long term, but structuring your portfolio in a way, which means you’re able to meet short-term income needs. So, the bucket portfolio method allows for an investor to stay invested in aggressive assets for a longer timeframe. So, bucket three can be filled with aggressive assets. Bucket two is filled with income-producing assets and bucket one is filled with cash. Bucket three refills bucket two, bucket two refills bucket one – saying bucket a lot. This structure provides diversification, income, and also increases the amount of aggressive assets you can hold.

So, Mark, some of our long-time listeners know that you actually manage your mother’s portfolio, Karen, and you manage her retirement portfolio, and you do use that bucket portfolio method. So, did you want to talk a little bit about how you use it and how you use it to increase the longevity of her portfolio?

LaMonica: Well, my mother does get excited when her name gets mentioned. And Karen is her name. Shani is not calling her a Karen. But when I looked at my mother’s portfolio, I took a slightly modified approach with two buckets. So, one was shares, but my kind of shares, so boring businesses that pay dividends, which are generally less volatile than the market as a whole, and then one bucket with cash. And that’s really because I just don’t love bonds. So, so far this has worked. I periodically sell down some of the assets and then there’s the dividends and that keeps that cash bucket full. And the cash bucket is used to support her spending needs and of course provide a buffer as well, which is the whole point of the bucket portfolios.

Jayamanne: So, let’s move on from asset allocation. Another variable is contributions. If you want a higher chance of reaching your goal, contribute more to it. This is one of the only levers that’s completely within your control and it’s central to my investment strategy. I maximize my contributions to increase the chance of getting to my goals quicker. And at the same time, if market returns are lower in the future, it means that I’m increasing the chance that I’m actually going to get to my goals on time.

LaMonica: Another lever is time horizon. So as an investor, you have the option to let time work its magic. So, if you have the capacity to stretch the time horizon of your goal, you have a longer time to contribute to it, a longer time for your investment growth and earnings to compound.

Jayamanne: And an example that I used in the article comes from our Investment Management team. They put together a model that explains how much you’d have to save to have a million dollars by 65. And this is just a model, so it’s illustrative of how time can help you reach your financial goals hand in hand with compounding. But it doesn’t include fees or taxes or any of the other realities that come with investing. And it gives an investor a 7% return.

So, when you’re 25, you need to save $405 a month. When you’re 45, you need to save $1,970 a month. At 25, the amount you’ve actually saved is around $194,000. So over $800,000 of that million dollars comes from investment returns and compounding. So, compare that to a 55-year-old where they’re saving $5,846 and $704,000 in total. So, they only get $298,000 from compounding and market returns in comparison. So, the longer you’re invested, the more your investments compound.

LaMonica: So, start young when you’re Shani’s age, not when you’re my age. That’s the lesson…

Jayamanne: That’s the lesson.

LaMonica: …to just break it down. So, if market returns are lower and you’re unable to contribute more to your goal, extending that time horizon may be a good option for you. Longer time horizon also allows you to invest in more aggressive assets for longer.

Jayamanne: And ultimately, 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 favor. Markets have had a good run. So be wary as an investor projecting this into the future.

LaMonica: In parallel to this, the correlation between asset classes has shifted recently, as you mentioned, Shani. So, 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 timeframe.

Jayamanne: And what’s important to me is ensuring that I am maximizing the success of my portfolio through measures that I can control. I’m ensuring that I maximize my contributions, as I said, so they can compound over longer timeframes. My asset allocation is aggressive because I take a long-term view. My portfolio is linked to my financial goals that are being realized within the next 10 years, which means I don’t need assets that temper volatility. I carefully consider costs in my portfolio, so they don’t meet whatever returns I do have in the share market. What about you, Mark? What are your thoughts about markets going forward and how you’ve structured your portfolio to improve your chances of achieving your financial goals?

LaMonica: I thought I would talk about maybe how things have shifted over time. So, if I compared my overall financial situation right now to where it was when I was your age, I would say, at a high level, things haven’t really changed. So, I still invest in dividend-paying shares. I’m still following a similar strategy. But there are two places that it’s different.

So, the first is that I hold more cash. I’ve just felt comfortable upping my cash, so my emergency fund or whatever you want to call it, because I’ve grown more confident I’m going to reach my goals. And I think that’s really a product of the great returns that we’ve had. And the cash ultimately just helps me sleep better at night. And I also think stemming from the same confidence that I’ll reach my goals is the fact that I’m spending a meaningful amount of my dividend income, which I was not doing when I was your age. So, I still save and in one account reinvest those dividends. But I’m also deliberately making the trade-off because – basically trade-off of having a better life now versus more money in the future by spending that dividend income. And I just felt that I got into a point where I could do that.

So, I guess we’ll just end it there on my thoughts. Thank you all very much for listening. We really appreciate it.

Invest Your Way

A message from Mark and Shani

For the past five years, we’ve 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.

The book is currently in presale which is an important time to build momentum. If anyone would like to support this project you can buy the book now. Thanks in advance!

Purchase from Amazon

Purchase from Booktopia