Why Your 60/40 Portfolio Isn't Diversified

You've heard it countless times – don't put all your eggs in one basket. Diversification is a cornerstone of risk management, but most efforts leave room for improvement.

Here's something that might surprise you: according to AQR's research, 90% of the risk in a typical 60/40 portfolio actually comes from the stock portion. So much for that "balanced" approach, right?

The objective of diversification is straightforward: reduce volatility and protect your savings from ruin. It works by holding investments with low correlation to one another. In other words, you want investments whose price movements have minimal relationship with each other (low correlation) and don't crash at the same time. Preferably, the investments move opposite to each other, exhibiting negative correlation.

Traditional Diversification

Traditional portfolios use a huge number of holdings across many asset classes like stocks, bonds, real estate, and commodities. These portfolios are considered well-diversified because they contain hundreds or thousands of positions. To its credit, this style supports a massive number of investors and eliminates the need to worry about any single investment. It's no wonder that you see portfolios like this as the default choice in many retirement accounts today.

Asset-based diversification grossly oversimplifies portfolio construction. If you invested proportionately to the size of each market, you'd end up with more bonds than stocks, and that would probably not return enough for many investors planning on achieving financial independence.

Even a 60/40 portfolio is a significant departure from the market portfolio. It adds stocks, and along with that, risk and higher expected returns. Because stocks have three to four times the risk of bonds, the outcome of most traditional portfolios is driven primarily on how well stocks do.

When Diversification Fails

There's an old investing adage: "all correlations go to one in a crisis." The 2017 paper, When Diversification Fails, and many others, corroborate the sentiment. What researchers found was eye-opening: asset-based diversification is asymmetric. It seems to work only during good times and gets progressively worse during bad times.

This asymmetry is the opposite of what we want as investors. We want gains to run and losses to be limited. Instead, the effects of diversification disappear exactly when we need them most. "Apparently, fear is more contagious than optimism."

High correlations during stock selloffs show how many different types of assets crash at the same time. Low correlations during rallies show how diversification seems to work when it is least desired. Source: Page, S., & Panariello, R. A. (2018). When Diversification Fails. Financial Analysts Journal, 74(3), 19–32. https://doi.org/10.2469/faj.v74.n3.3

Diversify Across Risks, Not Assets

If you think about diversification as a risk management tool, it doesn't make sense to simply buy a bunch of different things if they're all driven by the same underlying risks. Asset-based diversification makes a false assumption that each asset class moves independently. It makes more sense to design a portfolio that diversifies across risk factors – assuming you can identify them.

There are many real world events that can impact groups of stocks or even the whole market: energy prices, supply chain issues, legislation, interest rates, demographics, changing customer preferences, and more. Researchers use statistical techniques to find risk factors that explain returns in groups of investments.

The factor that all stock investors face is called the Market Risk Factor. It is the force that generally drives all stocks up and down together. Two other well-documented risk factors that explain the returns of investments are called Value and Momentum.

The authors of Value and Momentum Everywhere showed in 2013 that Value and Momentum patterns appear in stocks across geographies, bonds, currencies, commodities, and more. Their results "indicate the presence of common global risks." They also state "Value and momentum returns correlate more strongly across asset classes than passive exposures to the asset classes, but value and momentum are negatively correlated with each other, both within and across asset classes."

The idea is that it should be possible to build a portfolio that targets multiple risk factors rather than targeting different asset classes. Such a design should be better diversified and be hopefully more robust in a crisis. Indeed, this seems to be the case for Value and Momentum strategies.

Value and Momentum strategies exhibit more desirable diversification benefits. Source: Page, S., & Panariello, R. A. (2018). When Diversification Fails. Financial Analysts Journal, 74(3), 19–32. https://doi.org/10.2469/faj.v74.n3.3

The Bottom Line

Left Coast builds portfolios by focusing on diversifying risk factors. We believe that doing so produces more resilient portfolios that hold up better when markets get tough.

The goal isn't to eliminate risk entirely – that's impossible if you want to grow your wealth over time. Instead, it's about being thoughtful and intentional about the risks you take, making sure you're compensated for them, and taking steps to reduce the chance that everything goes wrong at once.

Wondering how these concepts might apply to your specific situation? Every investor's circumstances are different, and what works for one person might not be right for another. If you'd like to discuss how risk-based diversification could fit into your portfolio, we'd love to hear from you. Fill out our contact form below – we're here to help make sense of it all.