Memo to the Investment Committee: Dare to Be Different

Executive Summary

The conventional 60/40 portfolio of today is not going to generate the kind of returns that investors say they need. Investors must seek to embrace the terrifying concept of being different. As the ghosts of many great investors past have amply demonstrated, being different is the path to investment success. However, such advice falls into the simple but not easy category, to borrow Warren Buffett’s expression.

Both human nature and the institutional imperative are serious impediments to the budding contrarian. There are few quicker ways to lose one’s job than being alone and “wrong.” But the appalling forward-looking returns to a standard 60/40 portfolio leave no choice. Owning U.S. equities today virtually ensures low long-run returns. Instead, investors should own as much international and, in particular, emerging market equities as they can.

Emerging markets are trading on a Shiller P/E of 13x. This is the level of valuation that generally gets me excited. We have not experienced permanent impairment of capital from this level outside of markets that have shut down due to war. This doesn’t guarantee short-term returns or that we have reached a bottom: cheap stocks can always get cheaper. But it does provide a compellingly attractive entry point for those with a long horizon.

Even better are the value stocks within emerging markets, which trade on single-digit Shiller P/Es. So, embrace career risk, dare to be different, and recall the motto of the Special Air Service: Who Dares Wins.

60/40 Won’t Cut the Mustard

The biggest single challenge facing investors today, in my humble or otherwise opinion, is that the returns to a conventional 60/40 portfolio look set to be somewhere between very low and zero. For example, Exhibit 1 shows the expected (and realised returns) to a 60% S&P 500/40% 10-year U.S. Government Bond portfolio. If you assume mean reversion in equity market1 valuations, the return in real terms (after inflation) is on track to be around 0% p.a. for the next decade. Even if you assume valuations stay where they are in equity space, you are only looking at around a 3% return from a 60/40 portfolio.


As of 12/31/19 | Source: GMO

Deploying capital in a 60/40 portfolio today falls short of Ben Graham’s definition that “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” By investing in a 60/40 portfolio today, you are taking on risk with little to no hope of a return. Of course, as Exhibit 1 also shows, this portfolio has done remarkably well over the last decade, which makes the advice I am about to offer even more unpalatable than usual. But the past is not prologue, and few things in life are as dangerous as driving while focused on the rearview mirror.