It is time to diversify the traditional 60/40 equity bond allocation

With interest rates trading at or close to zero percent in most of the developed world, investors have been questioning if government bonds still act as a hedge against periods of market stresses, which are usually negative for equities. One of the most important characteristics of the traditional 60/40 equity bond (and also the ‘all-weather’ portfolio risk parity) has been the negative correlation between equity returns and changes in long-term bond yields. Figure 1 shows that the 3-rolling correlation between US equity returns and the 10Y bond yield turned negative in the beginning of 2000s after being positive for decades (using weekly times series)

However, we are not confident that the correlation will remain negative (implying that bonds are rising when equities are falling) in the medium term, especially if we switch to more inflationary environment after restrictions are lifted. Even though the disinflationary forces will remain significant in the coming 12 to 24 months due to social distancing, investors must not assign a zero-percent probability of a sudden rise in inflation expectations in the future.

Figure 1

Source: Eikon Reuter, RR calculations

Why not swap some of your bond allocation, which currently offers a very limited upside, for gold, which offers ‘unlimited’ upside gains as money supply continues to grow dramatically in most of the economies. Figure 2 shows the performances (and drawdowns) of four different portfolios:

  1. A equity long-only portfolio
  2. A 60/40 equity bond portfolio
  3. A 60/35/5 equity bond gold portfolio
  4. A 60/30/10 equity bond gold portfolio

We can notice that investors would have got similar returns if they had held 5 to 10 percent of gold in their portfolio instead of bonds in the past 50 years. It is time to diversify the traditional 60/40 equity bond portfolio.

Figure 2

Source: Eikon Reuters, RR calculations