The myth of the traditional 60/40 portfolio

A lot is spoken about when it comes to correlation. We hope to break this down and explain what some of the investment jargon means, look at mistakes even the most seasoned professionals make, and the history of why they make those mistakes. 

Correlation is the concept of how one, or a series or assets move in conjunction with each other. If an asset moves up 1% one day, down 0.5% the next day, up 2% the following day and 0% the following day, then another asset that follows the same pattern would be said to have a perfect correlation or a correlation of 1 (meaning 100%). If instead an asset did the reverse, went down 1%, up 0.5%, down 2% then 0% on the final day, it would be said to have a perfect negative correlation of -1 (meaning -100%).

However, there’s more to it than that. In investing we also have the concept of beta. If an asset moved up .5%, down .25%, up 1% then 0% the last day – it would also be perfectly correlated. That is because the strength of the relationship between the relative movements between the assets is still 1 – it’s just that the second asset has a beta of 5, or 50%, to the first asset.

So, what’s the big deal with correlation? Well, in 1952 Harry Markowitz showed that the combination of less-than-perfectly correlated assets can lead to:

1. A better returning portfolio for the same volatility or
   
2. The same return for less volatility (here volatility was used as a proxy of risk – one we think is incomplete and often misleading).

However, this was ground-breaking work and won him a Nobel prize. The portfolio became known as the ‘optimal risky portfolio’ or ORP for short – and existed on something called the ‘efficient frontier’, crossing with something called the ‘capital allocation line’ which all finance professionals learn about in university and advanced finance courses – it consisted of 60% US equities and 40% US bonds based on the historical data to date. This was the genesis of the modern balanced portfolio or 60/40 portfolio.

A couple of things here. This 60/40 portfolio was taken as gospel, but by Harry Markowitz’s own statement in the paper, he is only concerned with the second phase of portfolio construction – that is using the forecast return, risk, and correlation of assets. The first stage is techniques in forecasting those very numbers! If you use incorrect numbers, you can’t have an optimal portfolio – and how can the past be a perfect predictor of the future? From the final two paragraphs of his paper:

I believe that better methods, which take into account more information, can be found. I believe that what is needed is essentially a "probabilistic" reformulation of security analysis. I will not pursue this subject here, for this is "another story." It is a story of which I have read only the first page of the first chapter. In this paper, we have considered the second stage in the process of selecting a portfolio. This stage starts with the relevant beliefs about the securities involved and ends with the selection of a portfolio. We have not considered the first stage: the formation of the relevant beliefs on the basis of observation*.

This is extremely important. History will not repeat. It may be similar, but the past will not be identical to the future. Therefore, using historical data to ‘optimize’ a portfolio must, by definition, lead to a non-optimal portfolio because the future results will be different to the past.

Here’s an easy way to understand it – future risk can be forecast using probabilistic methods (as suggested by Markowitz himself) with the highest degree of accuracy, but not perfectly. Future return can also be predicted somewhat (more accurately for some assets, greater variability for others), but not perfectly and again requires probabilistic methods. Finally, correlation is the least forecastable element. To develop a perfect portfolio you must forecast risk, return and correlation perfectly – which is impossible. Correlation alone is highly variable over time. 

The proliferation of conservative 30/70 portfolios and 85/15 portfolios prove it further. His 60/40 represented the ORP – one that had the best return per unit of risk (or volatility). If you wanted higher risk for the same risk/return, you needed to leverage the 60/40 portfolio, and lower risk involved adding cash to the portfolio while still maintaining the 60/40 equity/bond proportions. This is what it means to move out the efficient frontier. To change the mixes involved reducing the risk/return profile of the portfolio – something the mainstream market does routinely.

Conclusion

We believe that Harry Markowitz's work was both genius and extremely insightful – however, the investment world has forgotten something; his work implied the use of diversification to reduce risk, not to promote the 60/40 portfolio.

As explained by Harry Markowitz himself, the 60/40 portfolio was only optimal in 1952, in the US and in hindsight. We can surely do better now.

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