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Advancing and evolving is a constant for humanity. Whether it is technology, health or even social norms, things change – usually for the better. For example, in 1952 just two-thirds of families in the U.S. had a telephone and only one-third had a TV¹. Today, a small digital device in someone's pocket can communicate or stream content to and from anywhere in the world.
When it comes to investing, the industry is constantly evolving as well. Whether it be through new investment solutions, platforms to invest or even ways advice is received, there is a constant evolution. There is however one part of investing that seems to have been at a standstill – "modern" portfolio theory.
Modern Portfolio Theory’s "60/40 portfolio" was also developed in 1952², however it has yet to materially evolve. If most other aspects of the investment industry are always evolving to serve investors better, why shouldn’t investment portfolios?
The case for evolving the 60/40 portfolio
With this theme in mind, the Asset Allocation Team has created a 5-part series of papers that addresses the evolution in our approach to asset allocation. In the first paper, we discuss how the 60/40 portfolio has served investors well in the past, why evolution is needed now more than ever and the approach to asset allocation at TD Asset Management Inc. (TDAM).
Some of the key themes for why the 60/40 portfolio needs to evolve discussed in the first paper include:
- Return expectations have changed - Bond yields have been steadily falling over the years and have dropped to all-time lows. Lower fixed income return expectations combined with strong equity return expectations fundamentally alters what one can expect from a 60/40 portfolio.
- Diversification dynamics have changed - A negative correlation between bonds and equities is a basic requirement for diversification, however, we believe the primary risk to the traditional 60/40 approach afforded by diversification is that the negative correlation may weaken going forward.
- The search for yield has altered the risk relationship - Because of low interest rates, investors have searched for yield in riskier areas of the market, such as high-yield or emerging market bonds. While these assets can play a role in a portfolio, compared to less risky bonds they are much more positively correlated with equities which reduces diversification benefits and offers less protection from volatility.
The future of the 60/40 portfolio
Investors continue to have the same needs as they did in 1952; to achieve the necessary returns to help meet their goals, with the smoothest journey possible. However, the modern world has changed and so has the return outlook for major asset classes and the relationship between them. Just as technology has evolved, new innovative techniques and asset classes have enabled an evolution in portfolio construction. Innovative solutions can better align with client goals and provide higher returns, with improved risk mitigation.
Be sure to look for our upcoming articles that include the new ways in which TDAM views and explores a more modern portfolio.
¹Pearson, Stephen. "The Year 1952." The People History. Web. 20 Dec. 2016. http://www.thepeoplehistory.com/1952.html
²The Journal of Finance, Vol. 7, No. 1. (March, 1952) Portfolio Selection, Harry Markowitz https://www.math.ust.hk/~maykwok/courses/ma362/07F/markowitz_JF.pdf
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