Morningstar - Q2 2022 - 13

EXHIBIT 1
EXHIBIT 2
while the other three would do so with a mix
of alternative equities and real estate. In
other words, all five would make the 60/40
portfolio riskier to compensate for the fact that
bonds can no longer be expected to offer an
adequate return.
My own counsel (were I to offer such a thing)
would be to take the opposite course. Avoid
the temptation to become more aggressive when
investment opportunities seem scarce. Instead,
maintain the same 60% equity position but
consider reducing the portfolio's bond market risk
by swapping into shorter notes or even raising
cash. If long Treasury yields continue to rise,
as they have done since summer 2020, those
monies can gradually be reinvested into longerdated
securities.
But that is merely a gentle suggestion,
and a temporary one at that. More generally,
I do not challenge the wisdom of the
60/40 portfolio.
A Little Knowledge
I wasn't always so humble, though. When
1991 ended, I had been working at Morningstar
almost four years and was studying for my
Chartered Financial Analyst designation. That
made me something of an investment expert
(or so I believed). When ordinary investors bought
balanced funds, they were content to hold
the traditional asset mix of 60% in U.S. stocks,
40% in investment-grade bonds. That would not
have been for me.
What I would have selected I cannot state
for certain, since I didn't have much money at
the time, and what I did hold went entirely
into equities. But I can re-create my thinking,
with reasonable accuracy. By then, I was
thoroughly familiar with the core precept of
Modern Portfolio Theory: Individually risky
securities could be both prudent and safe when
held within a diversified portfolio. For the
informed investor, risk is to be embraced rather
than feared.
In that light, and based on both the latest
academic research (the seminal Fama-French
paper chronicling the achievements of
Yale's Allocation Versus Vanguard
Balanced Index
July 2001-June 2011
10-Year Annualized Return
7.54
7.54
9.18
66
4.79
4.79
33
00
Yale Allocation
Yale Allocation
Vanguard
Vanguard
Balanced Index
Sources: Yale, Morningstar Direct, author's calculations.
30-Year Annualized Return
EXHIBIT 3
Two Balanced Portfolios
Conventional
8.79
8.79
U.S. Stock Market
30-Year Annualized Return
12%
12%
8.26
8.26
Allocation (%)
88
60
44
U.S. Investment-Grade Bonds
Conventional
Portfolio
Conventional
Portfolio
Informed
Portfolio
Informed
Portfolio
Sources: Yale, Morningstar Direct, author's calculations.
40
00
Informed
U.S. Stock Market
U.S. Small-Value Stocks
Foreign Developed Stocks
Emerging-Markets Stocks
U.S. Investment-Grade Bonds
U.S. High-Yield Bonds
Foreign Developed Bonds
Allocation (%)
15
15
15
15
20
10
10
Balanced Index
Yale
Yale
Allocation
Vanguard
Vanguard
Allocation Balanced Index
Balanced Index
S&P 10%
Risk Parity
Sources: Yale, Morningstar Direct, author's calculations.
S&P 10%
Risk Parity
44
00
9.18
10-Year Annualized Return
9%
9%
10.19
10.19
8.88
8.88
88
The Following Decade
July 2011-June 2021
10-Year Annualized Return
10-Year Annualized Return
12%
12%
small-value stocks was circulating, although the
article had not yet been published) and what
struck me as common sense, I would have
altered the standard 60/40 formula. My informed
portfolio, as shown in EXHIBIT 3, would have
favored small-value stocks, high-yield bonds, and
foreign securities.
This version of a " sophisticated " allocation, of
course, is very different than what later
became known as the endowment model, which
features alternative assets. But in 1991, even
Yale's fund held mostly conventional assets. Also,
as a mutual fund analyst, I considered only
what could have been held by public funds.
That portfolio still makes sense to me.
There's always the danger that winning strategies
will languish after their success becomes
publicized. Even so, small-value stocks seem
a sensible choice, as they're clearly less
popular with investors than growth companies
and thus should command higher gains.
In the same light, emerging-markets stocks and
high-yield bonds carry extra risks that deserve
extra compensation. And, even if their
returns are not higher, investments from foreign
developed markets should deliver additional
diversification.
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