If you go to a financial adviser to chat about investments, here’s how your first meeting will probably go: They will ask you about your attitude to risk. How much money are you prepared to lose? What sort of loss would change your plans for the future? How soon might you need your money back? Then they’ll probably assign a number to it. One, if you are very scared of losing money (or close to retirement) to five, if you are pretty gung ho. Platforms will do much the same thing – dividing funds into categories such as “cautious,” “moderate” and “adventurous,” for example.
You could argue that the whole exercise is a bit silly. Most people think they’re happy to take risk to make better returns – until they actually lose money. Then they aren’t so sure that is what they really wanted. Still, there has to be some way of creating a base for portfolio construction, and this is it. Everyone gets a risk rating.
But then you get a portfolio based on that rating and that’s when the real problems start. Mainly, the more cautious, the more bonds you get; the more adventurous, the more equities you get. To pluck a couple at random: the Personal Portfolio Cautious Fund at Coutts is 58% bonds and the AJ Bell Cautious is around 50% bonds. Look at the portfolios from Brewin Dolphin, one of the UK’s big wealth managers, and you will see a similar thing; their risk-level 3 portfolios (the lowest they offer) are around 44% in bonds.
That’s worked well for a long time. For the last 20 years or so, returns between bonds and equities have been fairly uncorrelated or negatively correlated. So sticking them together in a portfolio has been a good way to diversify, while limiting losses in the bad times. Bonds were a wonderful hedge during Covid, when the sharp fall in interest rates pushed bond prices up. The catch is, this isn’t historically normal. Look back and you’ll see the returns from stocks and bonds were mostly positively correlated in the first half the century, negatively correlated through to the mid-1960s, positive again until the turn of the century and then negative again until 2022 – when bonds and equities went down together. It was also a pretty obvious dynamic in September, when 10-year US Treasury yields hit a high of 4.69% (a mere three years after they hit a low of 0.31%). The rise in the 10-year yield in 2022 (by 2.36 percentage points) represented the biggest selloff since 1788. In the same month, the S&P 500 fell 4.64%, the Nasdaq fell 5.72% and the MSCI World Index was down 4.5%.
Look at it across a typical 60/40 portfolio, says Deutsche Bank, and you see the consequences of this correlation change. Over the last 100 years, a 60/40 portfolio of equities and bonds has seen a nominal annual return of around 7% to 10% across the G-7. In the 2020s so far, a 60/40 portfolio is down 6.1% in real terms per year in the UK and 4.9% in Germany; it’s up a mere 0.7% in the US. In the UK, it’s already been the worst 60/40 decade since the 1800s. The indexes compiled by ARC, which creates these benchmarks for private-client managers, show similar miseries: Over the two years to the end of June 2023, investors in ARC Cautious strategies (which are weighted for risk against world equities but generally fixed-income heavy) have lost more than those in Equity Risk strategies (5.8% against 4.8%). More hints of just how unhelpful it was to be holding a lot of bonds last year in an effort to be super low risk come from the OECD numbers on total asset backed pension values as a percent of GDP. The UK, where regulation requires pension funds to be stuffed to the gills with low-risk bonds, saw the worst fall in the ratio in the world ( down 20.2% against 15% across the OECD).