The optimal portfolio for the next decade

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Roula Khalaf, editor of the FT, picks her favorite stories in this weekly newsletter.

The writer is head of asset allocation research at Goldman Sachs

Since interest rates began rising in 2022, investors have recovered from one of the biggest hits to their portfolios — and to their belief system about multi-asset diversification.

Rising inflation during the recovery from the Covid-19 crisis resulted in one of the biggest losses for multi-asset portfolios in more than a century. But until then, simple buy-and-hold portfolios that invested 60 percent in stocks, 40 percent in bonds had been wildly successful for the current generation of investors. Inflation has now broadly normalized. So what is the optimal portfolio for the next decade – is it good to go back to 60/40?

Modern portfolio theory advanced by Nobel laureate Harry Markowitz allows us to find the so-called “optimal portfolio” with the highest return relative to risk, including the potential for diversification. This portfolio can then be combined with cash or grown, depending on risk tolerance. In hindsight, the 60/40 portfolio did indeed deliver the highest risk-adjusted returns since 1900, but over continuous 10-year investment horizons, the optimal asset mix fluctuated widely and was rarely exactly 60 /40.

In fact, the optimal asset mix in the three decades leading up to the Covid-19 crisis was more like 40/60. Aided by low and anchored inflation, bonds had a strong bull market and provided diversification benefits by undercutting equities during episodes when investors adopted a “risk-off” approach. But since 2022, long-term bonds have underperformed. While bond yields are now higher and near long-term averages, rate volatility remains high. The yield curve of bonds with different maturities is also flat. These factors suggest little benefit over cash.

As a result of the poor performance of bonds since 2022 — but also strong returns in equity — the optimal portfolio over the past decade has shifted to roughly 100 percent stocks. Surprisingly, the value of long-term bonds in the portfolio remains in question. With more uncertainty about inflation in the coming years, as well as increased risk from fiscal policies and higher government debt to GDP, bonds have also become riskier.

However, holding only stocks in the portfolio seems imprudent after the strong growth and given the elevated equity valuations, especially in the US. Equity’s expected risk premium—that is, the potential excess returns for stocks versus bonds—are at the low end of their historical range. This may reflect continued inflation concerns or more long-term growth optimism.

We think the latter is more likely, in part because of technological revolutions like generative artificial intelligence and new weight loss drugs, but also because of the extraordinarily high profitability of the US tech sector. During earlier periods of high productivity growth, such as the 1920s and 1950s/60s, stocks also outperformed bonds for long periods of time.

However, potential negative trends for stocks include: deglobalization, both economically and geopolitically; decarbonisation, with more risk from commodity supply shocks and rising costs around climate change; and demographic trends such as lower population growth, higher levels of dependency and income inequality.

So for the next few years we see value in being more balanced again in multi-asset portfolios. Broader diversification is needed to diversify structural risks. The optimal portfolio for the next decade might be one-third stocks with a bias toward “growth” stocks, one-third bonds, and one-third real assets.

In that portfolio, growth stocks would provide more targeted exposure to productivity improvement and diversification of disruption risk. A key challenge is that stocks tend to predict higher productivity growth before it materializes, resulting in valuation expansion and an increased risk of overpayment. With stock valuations already elevated, investors will have to be selective in looking for the beneficiaries of the next technological revolutions.

Bonds would provide protection against stagnation with higher real yields. They are currently factoring in low inflation, but if price increases pick up, exposure to real assets in the optimal portfolio can help diversify risks. These include stocks with pricing power in areas such as infrastructure, real estate and commodities. Thus, investors can put an additional 20 percent of the portfolio in stocks on top of growth stock investments. The rest of the real assets can go into inflation-linked bonds.

This trip takes us to a roughly 60/40 portfolio. But the optimal portfolio for the next decade must address the potential for increased productivity growth and the risk of higher and more volatile inflation. This means more targeted exposures within stocks and bonds.