Fires. Flood. Plague. Swamp monsters walking the earth. All the signs are here. We just have to have the courage to see The Truth: the traditional portfolio allocation of 60% to equities, 40% to bonds is coming to an end. (At least for now.)
It used to be that investors could count on stocks to do well when bonds were down, and vice versa. (This has never really been the case, but the myth has been generally accepted to be true, thus reinforcing its own legitimacy in the way self-fulfilling prophesies tend to operate.) Now investors face markets where all assets are trading at such high prices that it is difficult to see how a portfolio of financial assets can deliver returns sufficient to meet return requirements: $1 of US large company earnings will cost you $21.70, versus the 20 year average of $15.40; yield on US government debt is less than the rate of inflation at 1.5%.
The 60/40 portfolio was always a bit of a bad mix, however; it derives almost all of its risk (and therefore return) from stocks, and so is over-exposed to US equity investor sentiment. Modern Portfolio Theory suggests (and empirical evidence has proven) that better portfolios can be built by diversifying the source of one's risk: switch out some US large cap stocks for European and Asian ones, for example. This has the effect of increasing return while lowering risk, assuming that the assets under examination are not substantially correlated.
Now investors have to diversify not only their sources of risk, but their sources of safety, too. Gold has always been an effective hedge against financial panic. Indeed, this is the only reason to hold gold--unless you enjoy wearing it, too. Some investment managers are calling for adding high quality corporate bonds to the safe asset mix to replace yield lost to Central Bank loosening. This is not crazy, as Central Banks are propping up corporations with unprecedented lending schemes, and so their default probabilities, while non-zero, are nonetheless very low. If only the yield they offered were somewhat compelling, this argument would win the day. Perhaps it yet will. Better than corporate credit, we believe, are infrastructure assets, as these are backed by firmer and more value-erosion-proof productive public assets for collateral.
Besides diversifying sources of safety, investors will have to diversify further their sources of risk. Merely adding geographical diversity has long been insufficient to diversify portfolio risk. Investors have to embrace higher-volatility assets such as commodities, emerging market debt and equity if they hope to achieve target returns. Similarly, Real Estate Investment Trusts, which feature characteristics of both stocks and bonds, can be used to supplement both the risky and safe portfolios, given their dual nature.
While very little is clear in the teeth of financial crises, one thing that we can be confident of is that the future won't look like the past, and fortune will favor the bold. Investors don't have to wildly change their portfolios, or go way out on the risk curve to replace the risk lost to high prices paid, but they will need to do something different, or embrace the expectation of lower return.