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The "Balanced Portfolio" is broken (and here's how to fix it)

The "Balanced Portfolio" is broken (and here's how to fix it)

| October 19, 2019

Once upon a time...  there was a balanced portfolio.  And foundations and retirees lived happily ever after.

The End

Fortunately, that's not the end.  But things have truly changed, and investors are having to adapt their "balanced portfolio" to some new realities.


When interest rates were higher, investors could create a simple, conservative balanced portfolio of 60% stocks and 40% bonds.  They could successfully skim off 5% per year from a mix of dividends (from stocks) and interest (from bonds) in this account.  Investors such as charitable foundations, or even retirees, generally didn't have to "spend principal" (i.e., harvest capital gains) to meet their needs.  And life was pretty good.

With the advent of lower interest rates, investors later adopted a "total return spending policy" that focused on spending capital gains when necessary.  It was a good solution when stock returns were robust, but less so when they declined.  This "balanced portfolio" needed to be a bit more aggressive than before, but it generally worked.

Fast forward to today. Projections of high stock market returns and decent interest rates are hard to find.  Rates are barely above zero, and most investors' expectations, including our own, are for more modest stock returns in future years, versus the past. 


Needless to say, investors still need both higher income investments and securities that have the potential to appreciate (in the manner that stocks typically did.)  A perfect investment, therefore, would combine both -- that illusory 5% cash flow yield and the potential for equity-like total returns. For some reference, large cap stocks have averaged total returns of 9-10% per year, including dividends.  

But where are such investments?

Increasingly, investors are looking to private markets for investments with such characteristics. For investors who can tolerate the lack of trading liquidity in such investments, this can be an attractive option. 

Many investors overestimate their need for liquidity. In fact, many fail to see their IRA and 401(k) assets as illiquid, even though they can't touch some of these balances until they are in retirement --  which might be a decade or more away.  So, if we live with illiquidity every day, shouldn't we take advantage of the performance premium that often comes with this risk factor?

The fortunate offset to illiquidity is the fact that such assets aren't repriced daily the way stocks are.  While a lack of price volatility isn't necessarily an indication of lower overall risk, it is a nice factor to have in one's portfolio when market volatility is high.  And, if over time, such investments can compound with equity-like returns without equity market volatility, well that's a good thing.  And we should seize such opportunities whenever we can find them.


It's important to look at private investments in a portfolio context --  examining the characteristics that each investment brings, and how its returns might be correlated with other holdings.  Some investments can serve as a core allocation within the portfolio, while others should be used more sparingly.  Such allocations are determined by the risk tolerance and return needs of each investor.

While some private investments carry high risks (i.e., venture capital), other private asset categories can be considerably more stable. Investments that have a higher cash flow component of their total returns are typically more predictable. Certain real estate categories, such as affordable housing, tend to be less economically sensitive, owing to their more stable tenant bases.  Other "infrastructure" categories, including energy production (i.e., wind and solar renewables) are based on very long-term contracts with high and stable cash flows.  This is also a recipe for more predictable returns.

Such private investment categories can find their way into the new balanced portfolio by playing the "stability and income" role previously held by fixed income.  At the same time, these investments also offer potential for stock market-like total returns. (These two in particular also have characteristics that appeal to "impact investors".)   

At the riskier end of the investment spectrum, private equity strategies (those that invest in relatively mature private companies) look more like the stock market end of the allocation, with a focus on growth versus income. Private equity investments have historically earned higher returns than have large cap publicly-traded stocks. So, a small allocation to "PE" can have a large potential impact.

Meanwhile, funds that provide credit to mid-sized companies have taken on a role that was historically played by banks.  Investors in this "private credit" sector have also earned attractive returns over time (often in the 9-11% range) largely from the relatively high rates of interest that private companies must pay.

Together, one can start to see how private investments can rebuild the "balanced" characteristics that served investor so well in the past.  Robust income flows can be generated, and appreciation potential can be incorporated across multiple independent sources.  "Independence of return drivers" is an important characteristic when one wishes to diversify away from equity market risk.  And since these strategies don't reprice daily, overall portfolio volatility tends to be lower, too.

There is potential here for a win-win for those investors who can segregate a portion of their portfolio for illiquid, long term strategies.


The Yale (University) Endowment is famous in investment circles as a pioneer in portfolio management.  Their innovative approach to investing has helped them to earn returns that outpaced their peers' results for more than twenty years.  And while their approach doesn't apply to every investor, we can all be inspired by their example.

Yale determined that their endowment would be designed to operate into perpetuity.  They needed only a modest amount of liquidity to support their programs for the university, but rest of the principal would remain invested, year after year. They decided to maximize their returns with only a secondary regard to the "liquidity" of their investments. 

How does this look in practice?  In a word:  Different.  Today, Yale has only about 5% of its portfolio in publicly-traded stocks and another 6% in traditional bonds.  Their growth and their income are derived largely from private investment strategies. Think about how different Yale's portfolio is from that of the typical investor, who presumably has less ability to take risk than Yale does! 

Put another way:  Does Yale's embrace of illiquid strategies make their portfolio less risky than that of the typical American investor?  If that sounds perverse to you, it does to me, too.  But it's probably true.

Individual investors may not be able to follow the Yale model, and it is surely not without risks.  But understanding one's true liquidity needs can help each investor to build a portfolio that is balanced, income generating, and has appreciation potential under a variety of market and economic environments.