Your portfolio’s return comes from two places. Stocks offer price appreciation and dividends; and bonds provide income from coupon payments and the return of principal. Of course, because bond yields have been low for a prolonged period of time, investors may be tempted to chase yield.
However, remember that today’s highest yielding asset classes – the ones you may be tempted to chase right now – tend to be the poorest performers in subsequent years. And taking on more risk in the fixed income side of your portfolio can put your portfolio’s total return at risk.
In some circles, as the traditional portfolio comprised of 60% stocks and 40% bonds has come under fire, a new strategy has emerged called “Risk parity.” Risk parity attempts to reduce the risk of today’s 60/40 portfolios by investing in a wider range of asset classes such as stocks, government bonds, credit-related securities and inflation hedges such as real assets, commodities, real estate and inflation-protected bonds. At the same time, the strategy seeks to maximize gains through financial leveraging.
A prolonged low interest rate environment, market volatility, and outperformance by a particular asset class are all factors that can push investors toward more exotic investments. However, some of these investments may be illiquid. Some may lack transparency. And that increases, rather than decreases risk.
In fact, as Jason Kephart notes in his article, Old-School Portfolios Shine as Risk Parity Struggles, risk parity has not been a productive solution. He writes, “The $19.5 billion Vanguard Balanced Index Fund (VBINX) which maintains a 60% allocation to the total U.S. stock market and a 40% allocation to the Barclays U.S. Aggregate Bond Index, and re-balances regularly, was up 5.48% this year through June 24, while risk parity, a popular alternative, is underwater.”
Delivering a solid long-term, total return means focusing on more than boosting current low yields. In all market environments, a properly diversified global portfolio allocated between stocks and bonds is the best way to control risk – and increase the probability of enhancing returns.