by Zain Jaffer
Author’s note: This is only commentary and not financial advice. I do hold US stocks and Treasuries, and several ETFs. Talk to your financial adviser about any moves to be sure.
In the investment world, the term “60-40 portfolio”, has become quite popular ever since John Bogle of Vanguard released their Balanced fund several years ago. A 60-40 portfolio generally means having 60% US stocks and 40% US Treasury bonds.
During the past few years the 60-40 portfolio has provided good returns from the S&P balanced with good stability from fixed income US Treasuries, with only a few years going below expectations. Generally during periods of recession, many stocks go down, or perhaps the stocks in the 60% allocation were beat by others that were not selected.
Generally if you think the US economy will do well and the government does a good job, the 60-40 allocation work well. When the US economy grows, this shows in the value of the S&P because a stock market is a present value indicator of expected future revenues for different sectors.
However if the US economy is expected to contract, then problems occur. During periods of recession where the economy shrinks, stock share prices fall to reflect the projected smaller discounted present value revenues they are expected to get.
In addition, if the US Congress fails to rein in spending, then the US Debt to GDP ratio [https://usdebtclock.org/] will keep growing. Already some bond holders and buyers are hesitating to buy more Treasuries because of this. The analogy is that the US becomes like a credit card holder who does not pay their bills when due but still insists on charging more to their card. To attract buyers, the US Treasury is likely to offer higher yields, which in turn raises our interest payments and thus our deficit even further.
Plus when the US sells Treasuries to print more money, that money is increasingly backed by debt instead of actual revenues from tariffs and tax collections. This causes inflation to rise because more currency in the system is chasing after goods and services. An analogy is if there are enough buyers with money to buy limited tickets, they will drive the prices up.
So what is the ace up your sleeve. It is basically an uncorrelated hedge. Correlation is when something closely tracks another thing when there is movement. An inverse correlation is when the opposite is true. If the two move independently with no pattern, then there is zero correlation. Thus if you wear a blue shirt and your friend shows up with a blue shirt, and so on, you two are positively correlated. If you wear black and your friend wears white, and vice versa, then you two are negatively correlated. If there is no pattern between you two, then there is no correlation. “Correlation does not mean causation” as statisticians like to say, but if it happens often enough people use that as a basis to make decisions anyway.
In the current situation, it would be wise to have an uncorrelated hedge to your 60-40 allocation. This is your ace up your sleeve. The actual percentage is up to you.
An uncorrelated hedge, like insurance, protects you in situations where both stocks and bonds underperform, due to the reasons I described earlier. Basically you want some of your wins to counteract losses in your 60-40 portfolio. If all your bets are correlated, then you will end up losing money.
Some uncorrelated hedges include gold, silver, Bitcoin, Bitcoin ETF, cryptos, commodities, oil, futures, fine art, luxury watches, and others. Their price movements are different from that of stocks, which is what you want.
However you need to keep these allocations to these risk-on assets small, so that if these go to zero it will not be enough to wipe you out. You also want to pick uncorrelated hedges that have a high chance of outperforming the S&P500 if these do well. In other words, if you are going to take a risky bet, the upside ought to be better than stocks. Else why bother?
In finance, an asset should ideally have a high alpha (return over the S&P500) and a low beta (volatility). Often however the outsized returns come from the highly volatile and very speculative assets such as Bitcoin and cryptos.
If you feel that an asset is extremely volatile, but has an explosive potential upside, then just go for a small position. If you lose, it will not be much. But if it goes parabolic, at least you could offset any losses from your “safe” 60-40 allocation. Instinctively perhaps you already know this. Again the ace up your sleeve analogy.
Is the 60-40 portfolio still relevant? Not in its pure form. I believe you need to augment it with a small uncorrelated hedge to make it roughly more like 58-38-4 portfolio. The 4% is up to you. Ifd you are young maybe size it up. If you are retired, maybe keep it small.
No one can predict the future. People get run over just crossing the street. But if you have a small amount of uncorrelated assets, it may be the hidden ace up your sleeve that preserves your capital despite the economic twists and turns you might encounter in the future.
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