Is it time to reconsider the 80:20 rule before it gets trumped?

Maintaining the “status quo” is a very powerful force in portfolio management, just as it is in other areas of life. However, investors should consider whether maintaining the status quo is best serving their interests right now. While we have seen dramatic changes in the political status quo this year, investors’ portfolios have yet to adapt to the changed world we live in.

Most investors’ portfolios are typically designed for a moderate-high growth, low inflation world given their bias toward being long equity, property and bonds, with only the weighting to each of these asset classes varying (the idea being that each of these asset classes is not necessarily highly correlated).

The problem is that the actual state of the world now appears to be markedly different from what traditional investor portfolios are designed to benefit from. Namely:

1. The developed world appears to be suffering from a growth problem. The global population is quickly aging and governments are increasingly highly indebted. To us at least, it’s hard to see how growth will not be lower in the future than what we have historically been led to expect. A world in which growth is lower is unlikely to provide a strong tailwind for equity and property investments over time, save for temporary periods of growth as a direct result of even more deficit related spending.
2. Interest rates have reduced around the world to exceptionally low levels (negative) in some cases. They have only very recently started to move upwards. In our view, this has led to many assets being priced very expensively and at a premium versus their own history. As interest rates gradually increase, even if just a little, property and bond investments are at direct risk as are equity investments as rising discount rates are priced into valuation models. Effectively, just as lower interest rates drove up the prices of these assets together, the reverse is also likely to occur. Correlation of previously uncorrelated asset classes has been high on the way up as we expect it will be on the way down.
3. Inflation has been very low in recent times as the general economic backdrop has in fact been quite deflationary. It has however started to move upwards recently and could move higher yet in response to years of accumulated monetary stimulus exacerbated combined with moves in the US (in particular) toward deficit-financed fiscal stimulus and populist protectionism.

Given this backdrop we query whether investors should continue to rely on potentially outdated constructs when it comes to the composition of their investment portfolios. Just as it now seems quaint to not have a mobile phone we believe that in time an investment portfolio modelled in the traditional manner may come to be viewed in the same way. Even if interest rates remain low, returns from traditional portfolios may be very modest indeed given their starting valuation levels.  

Add to this that many investors can’t (despite what they may say) stomach the large drawdowns and high levels of volatility that are typically associated with traditional portfolio construction and we question why they should even bother given the availability of alternative assets (‘alternatives’) that can be used to genuinely diversify and add real alpha (and not just beta disguised as alpha) to their portfolios?

Unfortunately, we know that few investors allocate more than 20% of their portfolios to alternatives.  The volatility/risk of the alternatives they are allocated to is typically much lower than their equities and property investments but their allocation is often too small to rescue their portfolio performance from the potential damage caused by the remainder of their portfolio allocations.

Good alternative investments generally do not rely upon the performance of the underlying market to achieve their objectives, and can hence perform well regardless of what the overall market is doing.  Indeed, at Harvest Lane we welcome periods when traditional portfolios are weak, as they typically reinforce our value proposition to clients given our portfolios don’t rely upon market movements to make money.

In the investment environment of today, we believe the typical portfolio allocation of 80% to long only equity, property and bond investments - and only 20% to alternatives - is greatly misplaced.  Anyone looking to genuinely diversify a portfolio and better prepare their investments for greater volatility wouldn’t - and shouldn’t - tolerate the correlated risks of the equity, property and bond markets driving their entire portfolio outcome.

If it feels like old ideas aren’t working anymore, that is because they’re not.  Status quo portfolios are at risk of performing poorly in the years ahead just as status quo politics has in 2016.  

All investors should critically assess the assumptions their portfolios are built on, and look to construct portfolios which are, in our view, better placed to perform in the world we now live in.  Questioning the 80:20 rule – and potentially flipping it on its head - is a good place to start.