Why A Balanced Portfolio Is No Longer Fit For Purpose

Talk to your grand-parents about the strategy their investments follow and they invariably mention that it Is a balanced portfolio. This approach was widely considered a good compromise. This was between the wealth increasing but volatile equities, and the steady and boring bonds. The margin of safety that bonds provided were seen as ideal for calls on capital. Today, with the interest rate environment having changed completely, balanced portfolios no longer do 'what it says on the tin'!

Takeaways

• What is a balanced portfolio

• Which events are causing all the trouble?

• A potential solution

What is a balanced portfolio?

A balanced portfolio is one which involves both low and high risk assets. Equities are considered high risk and bonds low risk. The low risk portfolio may also include assets such as gold and infrastructure funds.

In periods of instability the price of bonds holds up well whilst the equities tank. As a result your portfolio volatility is reduced. For those who may need to raise cash can do so by selling the bonds, which theoretically will have lost less value.

On the other hand, if times are good the equity portion of your stock portfolio should perform well. This will grow your wealth. Typically a balanced portfolio will have a 60% weighting to equities and 40% weighting to bonds and cash.

Why is a balanced portfolio no longer fit for purpose?

The environment we are in means that the balanced portfolio is actually riskier than what it aims to be. This is  problem. With any risk management strategy you should understand the risk and your tolerance. If the risk you are taking is bigger than you realise, when things go wrong (and they often do with markets) you will panic and potentially makes your loss worse.

Yet if you understand the risk you are taking, and are comfortable with it (risk tolerance) you can (to some extent) ignore any volatility because you know you can 'weather the storm'. This subtle difference may not sound much. Just wait for the day when you wake and see your account down -50% in a manner you did not expect. I do not recommend it.

The reasons the current environment has made balanced portfolios riskier is due to a combination of factors which we have explained below.

We are in an interest rate increase cycle

The advent of quantative easing has led to too much money chasing too few assets. This has resulted in red-hot inflation. This inflation has been close to double figures in several nations. As a result central banks across the world have responded by raising rates.

An increase in interest rates means bonds need to price this event in. As the coupon to most (not all) bonds is fixed, the only way for a repricing, is the value of the bond. Sadly, this means down, or loss of value. As a result the asset which is supposed to hold its value with reduced volatility becomes the exact opposite.

Volatility is everywhere

For the purpose of this article, I have chosen to focus on bonds as the low-risk part of a balanced portfolio. Having said that, gold and cash often feature as well. Unfortunately, both these assets have proven volatile. During the March 2020 Coronavirus caused financial market sell-off, gold also dropped in value.

At the very time where one would have expected to appreciate it did the opposite! It later transpired that many investors had used leverage in their portfolios and when margin calls were sent to them, gold became a favourite to be sold. So much for being a store of value.

The same happened with US treasury bonds which are also seen as extremely safe. They also dropped in value in unison.

Cash is not better, unless it is the US dollar. Any other currency, (Sterling lovers in particular) has been pummeled by the strength of the dollar. If you live, work and save in one currency, Forex fluctuations are not a problem. Unfortunately, many of us take holidays abroad and are increasingly living international lives.

We are faced with the risk of being in the wrong currency at the wrong time. One way round this is to hold some of your cash savings in foreign currency. If your life is sterling-based then one solution is too hold 20% of savings in  US dollars and 20% in Euros.

Bonds may no longer be the safe asset they were

Historically bonds are widely considered one of the safest forms of securities. The US 10 year treasury and German 10 year Bund are the front of the queue. Unfortunately some governments behaving badly has meant these is no longer necessary the case.

When the bank manager rings to say you are running out of money, you do not ignore him. Cue the British government doing just that. At a stroke, UK inflation-linked bonds ('Linkers') have lost substantial value despite being designed to protect investors against inflation. This is due to financial markets not agreeing with the UK chancellors view on the UK economy's strength. 

Is there a solution?

Yes but not a perfect one. It consists of accepting that your risk profile will be more volatile. It means holding more equities but doing so in a sensible and efficient manner.

Buying and holding Index-tracking ETFs, specifically ones which track main markets can provide a solution. If you buy the S&P500, FTSE100 and STOXX50, you will gain regular dividend income with less risk than individual equities.

Although they cannot replace bonds when it comes to price stability, they are attractive in that each tracker holds at least 30 individual high-quality large companies. Remember diversification is a part of risk mitigation.

Conclusion

There will be a time when a balanced portfolio becomes an attractive proposition again. A time of increasing interest rates is not one of them. Indeed once government bonds yields increase to near 5% on 10 year debt, you will likely see the narrative become more positive on balanced portfolios.

This will be because a 5% yield on a government bond is infinitely safer than a 5% yield on an equivalent equity share. Remember life evolves and changes, so does investment. Look out for central banks forecast of stable or decreasing rates, this will once again make a balanced portfolio attractive.