One reason economics is hard, and why I love it, is that we have models that act as parables to explain how the world works and guide us on how to manage risk.
We get very invested in these models; it takes a long time to learn them and hours in a library doing derivations in pencil with a very fine lead.
But the world is always changing, and with it the validity of the model – so you have to ask: Does it make sense anymore? Or do you just have to tweak it a bit?
Empirical economics helps us, because it is how we measure how well the model fits the world. But this raises challenges, too, because how do you know when the world has changed?
In theory, you should use all the data you have, but if the world changed in the last 18 months, can you really use data that is 10 years old?
I don’t mean this as another anti-econ rant. But what separates good from great economists is the curiosity and humility to constantly reassess the models we love so much. Otherwise, we are no better than actuaries.
This includes the 60/40 investment portfolio.
I believe a financial planner, who was not an economist, came up with it, along with a crude 4% drawdown rule. Nonetheless, I think it is a defendable portfolio in terms of a risk strategy.
A portfolio that’s 60% in risk and 40% in low-risk assets can make sense for some people, depending on their age, risk tolerance, etc. But it seems like every year since its inception people in the finance industry have questioned 60/40.
In the last decade, the problem was that bonds (which are normally in the 40% part) don’t provide enough of a return. The answer was to put higher-risk bonds or variable fixed-income-like assets in the 40% part.
Which was really just adding risk to the risk-free part of the portfolio – so why not just say risk reduction has gotten expensive, and if you need/want a higher return consider 70/30?
Now there is another reason to rethink 60/40.
If we enter a low-growth/high-inflation environment, then the correlation between stocks and bonds will flip (as it always does in extreme market events, though this may last longer), and 60/40 won’t provide the same hedge. I am not ready to throw it out.
If you thought a 60/40 risky/low-risk split was right for you five years ago, you may just need to rethink what’s risky and what’s risk-free.
Low risk may now be inflation-protected securities. Yes, that’s expensive, in a low-growth/high-inflation market, safety will cost more. So maybe you can no longer afford 60/40.
It is important to recognize that and adjust accordingly – either take on more risk with clear eyes or accept a lower return.
I suspect we’ll see many strategies that promise a free lunch, higher returns, and the same risk as old 60/40. But these strategies, again, are merely adding risk and are not truly 60/40.
Has China changed how we think about risk?
I wrote something about China for the November issue of the Spector, asking if China’s economic success (which did change the world and economy) should make us question the most basic and fundamental laws of economics: Is there growth without risk?
For the last few decades, China appeared to defy the conventional wisdom and has steady high growth heavily guided by the government’s hand. What’s so tempting about industrial policy is that it promises growth with no risk or no one losing money (except maybe the taxpayers).
I argue that Evergrande shows the limits of this strategy. Nothing beats markets when it comes to allocating risky capital.
When the government directs capital, you end up with lots of empty apartment buildings. I am also pessimistic that governments can pick innovators, since innovation is inherently a risky process where lots of people lose money along the way.
It is one thing to grow a lot when you are transitioning from a poor to a middle-income country, but maintaining status as a very rich country requires market discipline and constant innovation – and the price of that is the odd recession where people lose money, and then people lose elections. I don’t see China coming to grips with that trade-off.
The world may change, but there is still no free lunch here, either.