What is a balanced portfolio?

Nowadays, a balanced investment portfolio typically involves a combination of stocks, bonds, alternatives (such as gold) as well as cash. Why is this better?

Historically, a balanced investment portfolio was often defined by a 60/40 split—60% equities and 40% bonds. However, the modern multi-asset portfolio is more diverse, incorporating alternatives such as hedge funds, gold, infrastructure and real estate. This diversification aims to enhance the trade-off between risk and return. At Evelyn Partners, alternatives have always been part of our client portfolios.
The two-asset equity and bond portfolio has experienced periods of poor performance, most recently in 2022. When post-Covid inflation proved to be ‘stickier’ than central bankers had anticipated, expectations for future interest rates increased. This caused a corresponding increase in the yields of bonds, which meant their prices fell. 

Equities also fell into a bear market (usually defined as a period where stock prices fall 20% or more from their peak), spooked by inflation coupled with an increase in geopolitical risk as Russia invaded Ukraine. Both asset classes fell together; their correlation (a measure of whether they change together) became positive. 

Figure one below demonstrates the correlation between equities and bonds over the last 25 years. For most of that time, their correlation was in negative territory.  This means that they often moved in opposite directions – when equities rose, bonds often fell and vice versa.  This behaviour was attractive to investors because when equities fell, bond prices usually increased, dampening fluctuations in the overall value of a portfolio which included both.  

The events of 2022 were a wake-up call for investors with portfolios only invested in the world’s two largest asset classes (equities and bonds). Even those with more cautious portfolios, such as 30% equities and 70% bonds split, experienced unexpected losses - historical data suggested they wouldn't suffer as much, but the narrow, two-asset portfolio underperformed these expectations.

Investors in more diversified portfolios fared slightly better. In particular, some types of hedge fund strategies really proved their worth, as their nimble managers were able to take advantage of volatility and short-term trends.

The correlation between stocks and bonds has always varied. Investors enjoyed a largely negative correlation for the last 20 years, but before that, a positive correlation between stocks and bonds was quite normal. 

A return to that positive correlation doesn’t mean that we should entirely shun bonds or equities now, in favour of other asset classes. Bonds may have not exhibited the diversification characteristics that multi-asset portfolio investors hoped for in 2022, but they have been performing much better in recent volatile markets.

Gilts (UK government bonds) have rallied since the recent peak of the equity market on 19 February, and US Treasury bonds are up more. One reason for this is their valuation - bonds are a more attractive proposition to investors on prevailing yields of over 4% than they were in 2022, when they yielded 1% or 2%. 

This valuation may have given us a clue in 2022, but the real lesson is that there are always benefits to investors of more diversification in multi asset portfolios. It is important to remember that it is beneficial for portfolios to have assets which have a correlation below one to the rest of the portfolio, so stocks and bonds still work well together when they have a correlation of, say, 0.5. However, positive correlation between stocks and bonds does focus investors’ minds on the benefits of holding other asset classes, such as gold or hedge funds.

Figure two (below) shows the benefits of a more diversified portfolio. The red line shows the outcome of holding a portfolio of equities and bonds, in different proportions, over the last 20 years. The x-axis (horizontal) shows annualised volatility, a measure of risk in the portfolio, while the y-axis shows the level of historic return for that level of risk. Investors willing to take on more risk generally achieved higher levels of return – a key tenet of investment theory, which is generally true over the long term (although, as with all investing, this is never guaranteed).

The green demonstrates why diversification is important. Portfolios on the green line hold equities and bonds, as well as gold, hedge funds, real estate and infrastructure investments. The green line is always above and to the left of the red line. This shows that, for a given level of risk, one has generally been able to achieve a higher level of return from the more diversified portfolio, by moving ‘up’ from the red to the green line. Alternatively, one can achieve similar levels of return while taking less risk, by moving ‘left’ from the red line to the green line.

It is important to note that the portfolios in the chart represent the ‘best’ portfolios an investor could have held historically. It shows that including additional asset classes in portfolios gives us the best chance of improving returns and reducing risk, which is why we spend a lot of time considering asset allocation for our clients. 

Evelyn Partners offers combined wealth management services with professional advisors and investment managers who can help you work towards your financial objectives.

To explore ways to balance your portfolio, please book an appointment or speak to your usual Evelyn Partners contact.