Diversification is the only free lunch in investing. Although some, including legendary investor Warren Buffett, denigrate this well-worn idea, for most it’s a no-brainer to seek to balance risks by spreading them across a range of investments. When some prices fall, others should rise to help keep our wealth on a reasonably even keel.
This principle lies behind the classic 60/40 portfolio: 60 per cent risky shares and 40 per cent ultra-safe government bonds. For decades, this balanced portfolio has offered decent risk diversification—when share prices fell, bond prices tended to compensate by going up and vice versa.
But for how much longer? Since the 2008-9 financial crisis, yields on government bonds have edged ever closer to zero, and efforts to combat the coronavirus crisis have squashed them even further. The yield on the UK’s 10-year government bond is currently below 0.2 per cent. Because bond prices rise as their yields fall, investors in the UK and other developed markets are at a crossroads—unless yields plunge materially below zero, there is little scope for bond prices to rise further.
The corollary is clear: if bond prices have little room left in which to go up, the mechanism that has for so long successfully diversified risk in the classic 60/40 portfolio may be broken. That would remove from the menu the only free lunch investing has to offer, and would leave exposed any portfolio that relies on bonds to pick up slack when shares disappoint.
Unfortunately, to borrow from the parlance of Brexit, there is no “oven-ready” solution. In the end, the answer is for bond prices to fall from today’s stratospheric levels so that they regain their ability to tack up and down in the opposite direction to shares. But given the large losses a fall in bond prices will inflict, by the time they’re restored as effective portfolio diversifiers, investors will have bigger problems to worry about.
The direction of bond prices from here will depend largely on what happens to inflation. If it moves to 3-4 per cent for a sustained period, yields will rise and prices will finally fall. If the coronavirus recession intensifies deflationary pressures, yields will remain minuscule—and prices flat, if sky high.
Either way, the outlook for the classic balanced portfolio…