Former Morgan Stanley CIO James Helliwell argues the 60/40 stock-bond portfolio fails because stocks and bonds now fall together when rates rise. He proposes a tactical ETF model that shifts between equities, bonds, and inflation hedges based on market conditions, showing 17% compound growth versus 11% for traditional 60/40.
6 million people have watched this mind-boggling lecture on how to build a portfolio, and the man teaching it isn't some crusty old academic. He ran trading desks at Morgan Stanley for nearly 20 years, which is exactly what makes it so dangerous, because the theory at the heart of it stopped working years ago, and the industry, I think, has been covering it up ever since at the expense of your portfolio. Now, if you're new here, I'm James. I previously ran money as Chief Investment Officer to a number of funds in the city, and in this video I'll give you my inside take on the myth that the industry still hides behind, what it means for your portfolio, and how you can get better returns with just a handful of ETFs whilst avoiding the major losses that you and millions more investors could be walking right into. So it all comes down to something known as Modern Portfolio Theory, and you might already know the basics. The idea is really, really simple. It's that diversification is how you reduce risk. And by striking this balance between stocks and bonds, losses in one should offset the other. The entire industry runs on this theory, not necessarily because it works, but because the regulator adopted it and effectively has institutionalized it. Now, if you've ever had an advisor, it's why they have to ask you this standard set of questions to determine your so-called attitude to risk. If you're more adventurous, you might find yourself putting more stocks, and if you're more cautious, maybe close to retirement, you'll end up holding more bonds, which sounds pretty logical until you realize that the entire principle of Modern Portfolio Theory is fundamentally flawed. So let me show you what I mean with a couple of charts and how it failed spectacularly a couple of years ago. Now, for years, both stocks and bonds both rose at the same time. Which was brilliant because your diversified portfolio gained on both the stock side and the bond side. However, this was supported by 40 years of falling interest rates. So stocks went up, bonds went up, which made the traditional 60/40 portfolio, which you can see with this ETF, of course the history isn't quite as long, look amazing. But this wasn't necessarily evidence that stocks and bonds were providing proper diversification because in many respects they were both benefiting from the same macroeconomic environment. So then 2022 happened. We saw a load of inflation all of a sudden after the pandemic, and then the Fed racing to raise interest rates. So they went up at the fastest rate in 40 years. Stocks fell and bonds fell simultaneously. So there wasn't the safety that for many years everybody thought existed. And we sat with a nasty drawdown. Now, the reason this is most significant is because this regime shift hasn't gone away. We're now in a macro environment of structurally higher inflation and interest rates. So there was no diversification right when you needed it. And building a portfolio around these historical correlations is like driving looking through the rearview mirror. And that's the fundamental problem with Modern Portfolio Theory. It might look great on paper, but the market doesn't always behave like the maths geeks reckon it should. So if you accept the relationship between stocks and bonds, that it can change, then blindly following this 60/40 model doesn't make much sense. What you need is a model that will actually adapt to the environment that it's operating in, and that's exactly why I've built this tactical ETF model that I'm going to show you now. So I'll include a link to this in the description where you can go ahead and check it out, but essentially what we want to focus on here is the model, how this switches between stocks and bonds and inflation-protected equivalents only when necessary to ensure that it's always adapting to the current market environment, or the regime as we call it in the industry, and in so doing categorizing expansion versus slowdown and contraction And similarly, when there was upside risk to inflation or not, the model crunches all of the numbers and shifts the allocation accordingly. And what you can see here in the orange line is how that would have hypothetically performed compared to the 60/40 model, which is in blue, or buying and holding the S&P with the grey line. And the most important numbers are at the top. Not only a much higher return, seeing compound growth of 17% compared to 11%, but a shallower drawdown. And there's a much simpler way to understand all of this. I've actually programmed it into a basket of ETFs that it selects according to this. You can go through the allocation history again, link in the description if you want to check this other tool out. It's all in the same trial, and you can see how it dynamically shifted between different ETFs and sometimes back into 60/40 according to the regime. And this is the key thing. In 2022, it actually benefited by being adaptive to these conditions when everyone else was falling behind. So it's not what percentage of stocks and bonds does the textbook or the boffins say I should own, but what environment are we in? What risks am I actually taking? What happens to the portfolio if the assumptions underneath it, as we've just seen over the 40 years, suddenly change? And that all gets completely lost, in my opinion, in conventional theory, guys. And again, volatility isn't the only measure of risk. Risk is what happens when your assumptions are wrong, and that thing that you bought thinking it was safe ultimately falls at the same time as the rest of your portfolio. So you can be incredibly intelligent, you can have degrees from MIT, and even a career at Morgan Stanley for 17 years. But you can also still teach an outdated framework that's far less useful when you actually have to make decisions with your own money. So watch this video next, which YouTube thinks you're going to love, and we can take your learning even further. See you in a minute.
