Picture that you are driving on the highway but stuck in bumper-to-bumper traffic. As you crawl along, you notice that the adjacent lane seems to be going faster. You see a few cars go past you until you decide you’ve seen enough. You spot an opening and move into the quicker lane. What happens next?
Naturally, the lane that you just moved into grinds to a halt and to make matters worse, the lane you just abandoned now picks up and starts moving faster. Again, you see cars passing you. The adjacent lane seems to be going faster…
This maddening phenomenon is known as "lane envy" or sometimes referred to as the "grass is always greener" effect. It can be attributed to a combination of mental errors, such as the illusion of control, which lead to the impression that other lanes are consistently moving faster. Traffic flow can be quite variable, and switching lanes frequently rarely improves travel time. This is a highly relevant metaphor for investors who own a diversified and balanced portfolio, especially during the challenging markets of 2022 and early 2023. In this article, we will define what a “balanced” portfolio is, see how the performance of such portfolios over the last two years might feel like the lane envy effect in traffic, and consider whether there is useful advice for investors in the future from this example.
What is a “Balanced” Portfolio?
A balanced portfolio is an investment strategy that combines different types of assets typically stocks and bonds, to achieve a balance between risk and return. The goal of a balanced portfolio is to provide investors with a relatively stable and steady growth of their investments while minimizing potential losses.
Probably the most familiar balanced portfolio allocation is the 60/40 strategy, where 60% of the assets are invested in stocks and 40% in bonds. Over time, stocks provide the potential for higher returns but carry higher risks, while bonds offer more stability and lower risks but typically lower returns. By combining both types of assets, the balanced portfolio aims to achieve moderate growth while protecting the investor from significant market fluctuations.
Over the past several decades, balanced portfolios have provided attractive rates of return while reducing the experience of short-term market volatility. During the Enron and tech bubble period of 2000-2002, the 100% stock portfolio declined 11.6% per year while the balanced approach declined by only 3.3% per year over the same tough time. In the 2008 housing and financial crisis, the 60/40 portfolio suffered a bear market, declining 24.9%. The all-stock 100 portfolio lost a traumatic 40.1%.
Good data on the 60/40 strategy exists back to 1985, and the annualized return of a hypothetical 60/40 globally diversified portfolio since then is 9.4%. This is only slightly less than the 11.1% annualized return of a portfolio of 100% stocks over the same period.ii We believe that this reduction in performance can be a worthwhile trade for the less stressful experience during periodic market declines, making the balanced approach the superior vehicle for many investors. Ask yourself if you would be willing to endure the violence of a 40% decline in your portfolio value versus 24% during a bad year in exchange for the chance to earn another 1.7% over time.
The balanced portfolio accomplishes this because stocks and bonds tend to move in opposite directions in response to an event. At the risk of oversimplification, optimistic thinking tends to push stocks up, while pessimistic thinking tends to be good for bonds. When a pair of assets exhibits this behavior, they are said to be “negatively correlated”. This is the definition of diversification and the source of the balanced portfolio’s strength, but it is also the source of the balanced portfolio’s main structural vulnerability.
What happens when stocks and bonds go down at the same time? In other words, what happens when the correlation changes from negative to positive?
Out of Balance?
In 2022, global stocks as measured by the MSCI ACWI index declined by 18.37%iii. At the same time, the Federal Reserve boosted interest rates in response to exploding inflation, causing bond prices to plummet. The 10-yr US Treasury had its worst year in recorded history, dropping almost 18%. 30-yr US Treasuries lost 39.2%, their worst year since 1754 – before the founding of the United States of America!
In previous bear markets, a flight to the safety of Treasuries and other bonds helped protect investors in balanced 60/40 portfolios. In 2022, there was no refuge provided by bonds, leading a typical 60/40 portfolio to an overall decline of around 18%. This was its worst single year since the Great Depression, and the first time ever that both global stocks and Treasuries declined by double digits at the same time.
The 60/40 portfolio's failure revived the long-standing argument that its strategy is too rigid or even obsolete. Many people, even those who had been adherents of the balanced approach for many decades, began to agree that investments should adjust to current conditions instead of stubbornly sticking to an outdated strategy. Through the summer of 2022, balanced funds saw their biggest withdrawals since the 2008 financial crisis. At the same time, two seemingly well-timed investment approaches gained interest—tactical allocation funds, which change their positions based on market shifts including temporarily moving in and out of cash; and multistrategy funds, which invest in "alternative" assets such as options, gold, real estate, and commodities.v To return to our earlier example, the balanced portfolio lane of traffic was stopped, the other traffic lane was looking pretty good, and a lot of drivers were switching.
Just as it happens in traffic, you can guess what happened next.
Is a Balanced Approach to Investing Still Valid?
As we have seen, a “balanced” 60/40 portfolio provides a strong annualized rate of return over time, while providing some defense during a stock market decline. Such strategies have performed well in previous bear markets and recessions and provided an emotionally superior investment experience to their owners over the long run. However, balanced portfolios can lose value very quickly if both of its legs are swept at the same time. In 2022, this is exactly what happened. Balanced portfolios cannot withstand simultaneous impacts to bonds and stocks.
However, this fact does not invalidate the strategy. After the decline in 2022, balanced portfolios have benefitted investors who stayed the course and resisted the temptation to switch lanes.
But Why Couldn’t We See What Was Coming?
The inflation that occurred in 2022 was predictable to anyone who lived through 2020 and 2021, and the downward pressure on bond prices was obvious to anyone who understood the Fed’s clear intentions to respond to inflation by rapidly increasing interest rates. The danger to the balanced portfolio approach was easily apparent.
Being able to anticipate what is coming is a very different thing than being able to act on it in a beneficial way. Predicting the future is rarely as straightforward as it was connecting last year’s bond rout to the preceding inflation and monetary policy response, but even when it is, it remains nearly impossible to scratch out actionable intelligence.
Professional fund managers behind multistrategy and tactical allocation funds had an easy a shot as they will ever get in 2022/23. Neither inflation nor the Fed’s response were difficult to predict, so the struggles of a balanced portfolio were apparent well in advance. They still missed. One can imagine that do-ityourself traders or market timers likely suffered an even worse outcome, and there is no reason to believe that either they or the pros will do better next time. Many people were compelled to switch lanes, gave in to the illusion of control, and are now frustrated to see that they would have been further down the road and closer to their destination had they relaxed and just stayed put.
The Highway of Investing Success
It makes a lot of sense for investors to heed the lessons of the past. First, a balanced approach to investing has demonstrated enduring performance and value. Constructing a portfolio around careful diversification and negative correlation has proven to a good idea for the long run, even though we know that there are times when it can lose value because both stocks and bonds can go down simultaneously. These occasions are not proof that the strategy no longer works.
Second, having chosen their “lane”, investors should resist the urge to switch lanes based on the suspicion that one will be faster in the future. Predicting the future with enough clarity to act is really hard even with three lanes of traffic, and it is astronomically harder when it comes to portfolio management. Often, making changes based on predictions or the need to “do something” leads to frustration and disappointment.
In conclusion, just like the driver experiencing "lane envy" on the highway, investors should remember that constantly switching strategies rarely leads to better results. Sticking with a well-diversified, balanced portfolio can provide long-term stability and growth, even during challenging market conditions. The other lane might be tempting but staying the course and resisting the urge to switch lanes can ultimately bring you closer to your financial destination.
Frank Hujsa, CFP®, CLU®
Partner, Acadium Financial Partners
Financial Adviser, RJFS
Any opinions are those of Frank Hujsa and are not necessarily those of Raymond James. Securities offered through Raymond James Financial Services, Inc. member FINRA/SIPC. Acadium Financial Partners is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc.
Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance does not guarantee future results. The information provided has been prepared from sources believed to be reliable but is not guaranteed by Raymond James Financial Services and is not a complete summary or statement of all available data necessary for making an investment decision. Any information provided is for informational purposes only and does not constitute a recommendation. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct.
- DFA Matrix Book, 2022 pages 60 and 61. Calculations performed by the author.
- DFA Matrix Book, 2022 pages 60 and 61. Calculations performed by the author.
- www.morningstar.com, Morningstar Direct