Why the 60/40 Portfolio Doesn’t Always Protect Investors

During their recent episode, Jake Taylor and Tobias Carlisle discussed Why the 60/40 Portfolio Doesn’t Always Protect Investors. Here’s an excerpt from the episode:

[Tobias] And so in 2008, if you had used… So the classic 60-40 portfolio is 40% bonds, 60% equities, with the idea that when the equities go down, there’s this flight to safety, the bonds, the bonds rally, you rebalance out of the bonds into the equities. So you’ve got more money into the equities at the bottom.
It recovers. Didn’t work in 22 because bonds sell off too.

[Jake] Yeah. CLT did worse.

[Tobias] And then if you look at 60, 60-40s only worked for 20 years. There’s a short period of time where bonds and equities were uncorrelated. Most of the time they’ve been pretty correlated.

[Jake] Isn’t it interesting how these rules of thumb, heuristics, bromides come from small sample sizes often. Maybe it was 20 years it was true, and that was enough for a whole generation to say, well, 60-40, or stocks always outperform bonds as a thing. Like, well, yeah, in some narrow circumstances, that’s been true.

[Tobias] You’re always confronting that idea that there’s the past. What worked in the past is the past. And how far back in the past are you going to go?
20 years, that seems like a reasonably, that’s modern history, 20 years. Beyond 20 years, it’s ancient history. Why would that idea apply anymore?

[Jake] That feels wrong to me. That makes me feel old when you say that.

[Tobias] I’m not saying that’s my view of the world. I’m saying that’s a pretty widely held, that’s a reasonable view of the world.

[Jake] It still makes me feel old to hear.

[Tobias] The median age is 28.

[Jake] Of what?

[Tobias] Humans.

[Jake] Right now?

[Tobias] Yeah.

[Jake] Okay.

[Tobias] Might be 38 in a developed world, but I think that’s right.

[Jake] That’s pretty good.

[Tobias] Look that up, Hyde Mind. Tell me if I’m wrong. 20 years, that’s a significant, you’re a child.
20 years ago, if you’re 28, you’re a child, and everybody else is older than that.

[Jake] I was going to ask, do you know what the median age is in the finance industry?

[Tobias] Younger.

[Jake] It’s younger than that?

[Tobias] I don’t know.

[Jake] I don’t know either. But to say that if an entire industry, or a big chunk of the industry has one worldview that was moulded during a particular time, they’ve never really seen the out of sample, have they?

[Tobias] Right.
[Jake] I saw someone the other day say, my biggest worry- Do you want to get rich, or do you want to be a market historian?

[Tobias] Yeah. I think Rudy Havenstein said the other day, my concern is all the 45 year old PMs on desks who’ve never seen a, maybe a, whatever happened 45 years ago, who’ve never been in the market, haven’t been in the market long enough to see a bear market in bonds, maybe.

[Jake] Sure.

[Tobias] Yeah, maybe. Bear market in bonds, that would be 45 years since 1980.

[Jake] Well, but even if you’re 45 on the desk, let’s say- Oh yeah, you weren’t, you were a kid.

[Tobias] Yeah, you need to be, you’re 65, you’re retired.

[Jake] Yeah. No, no, I would say, I mean, under 30 for sure, it’d be hard to imagine that you’ve, you didn’t really live through 2008. And I don’t, I’m not sure I count 2020, it was so fast a recovery.
22 is also kind of relatively mild. Have you really taken the test yet?

[Tobias] Well, that’s one of the reasons that I like to go back through the data and have a look and see what happened, what, how you might react to it in the data. Well, the other, because I’ve tested other ideas in there as well. Like one of the ideas that I tested is the moving averages.

You know, lots of people swear by the 200 day moving average, the 50 day moving average, the crossover between the 50 or the 200. Do you use a simple moving average? Do you use an exponential moving average?

All of these various different things. I didn’t look at all of that in the book. I just looked at moving averages generally.

And the problem that you have is this, it doesn’t matter which one you choose. They all have the same problem. And it doesn’t, two in concert doesn’t help either.

You have this problem where if it’s Japan in 1990, and you’re like, you believe in this moving average and it kept you in right all the way to the peak. And then it plucked you out right at the very top and didn’t let you get back in until the bottom. And so as far as you’re concerned, like if Japan’s been a very mild market to invest in, the problem is that a lot of markets go all the way down to their moving average before they rally again.

So you’ll risk off. And then it depends on how often you’re checking. You’re checking monthly or weekly or daily.

It just creates more opportunities for whipsaws and over-trading and there’s no good solution. And so moving averages are trend strategies. And that’s an asset class all by itself that you can include, but it doesn’t solve all of your problems.

It works sometimes and it doesn’t work other times and it’s expensive.

[Jake] Does it work in the times where your other stuff is unlikely to be working?

[Tobias] It can. Yeah. So it might earn its place as- Diversifier.
As a diverse, as one of the uncorrelated streams that Dahlia looks for, but it doesn’t necessarily solve your problem.

[Jake] Does that, how robust is the data on like CTAs for that? Are there, is it like- I think if anything, it flatters CTAs. Where you get the 1970s create this very outsized perception.

[Tobias] Well, I think it flatters them because there’s so many that, the only ones who survive are the ones who win. The ones who don’t work, don’t survive. There’s a real survivorship bias in those, I think.

But then you have, so then what about hedging, buying options? So there’s lots of different ways you can do that. VIX calls, HYG, high yield debt puts.

[Jake] We don’t need to talk, Toby, about how much money we’ve wasted on VIX calls.

[Tobias] Well, I’ve lost it. I’ve lost it not only in VIX calls, I’ve lost it in HYG puts. And then index puts, like out of the money index puts as well.

And in every single one of those instances, I’ve had the event, I’ve been in the event, had the big event occur, had it be like a third of the portfolio worth of value. This is just in my PA. This is not a public strategy.

[Jake] And not investment advice.

[Tobias] And not investment advice, yeah. And in every single instance, they have expired worthless. And one of them was like, I can’t even remember now, like Christmas 2018, I was there with my dad.

My dad was like, geez, maybe you should take some of that off. I’m like, listen, you don’t understand. This is when it gets exponential.

You should take some off.

[Jake] Yeah. Well, the problem with the VIX calls was always that they were the European style. So they were only money good on the day of expiration.

And the whole rest of the market never moved the price really of the call because they all just assumed it would all die down before the end of the expiration. And they were right. So you ended up never getting, like you’d be money good and then actually not end up cashing any real checks, which is- That’s one of the problems with vol funds, right?

[Tobias] That you’re in the fund and it pays off, but it takes so long to get the results at the end of the next month or midway through the next month. And then it’s how long to take a redemption. Then you rebalance long and the moment’s gone.

[Jake] And you’re like tantalus. You’re just like reaching for the fruit that’s right in your PA already and then you can’t get your hands on it.

[Tobias] Yeah. That’s exactly right. You get to feel good, I guess, while it happens.

You’re not as blown up as it could be, but you don’t get to rebalance.

[Jake] You get to feel very intellectually superior for a week there, right? Even if financially it doesn’t- Yeah.