Harry Markowitz, the legendary economist and father of modern portfolio theory, has been credited with saying that diversification is the only free lunch in investing. However, his work on the efficient frontier shows that investors give up expected returns to lower expected risk. This may make diversification even more compelling. With uncertainty becoming a prevailing theme in financial markets and the global economy, focusing on the benefits on diversification could prove valuable for investors. The 60-40 portfolio may have lost its luster in the broad market selloff of 2022, but allocating across a diverse mix of assets is crucial in the long run.

This episode of The Outthinking Investor dives into the topic of asset allocation and the role of stocks, bonds and alternatives in a diversified portfolio. Our guests are Antti Ilmanen, Global Co-Head of the Portfolio Solutions Group at AQR Capital Management and author of “Investing Amid Low Expected Returns: Making the Most When Markets Offer the Least”; Scott Cederburg, associate professor of finance at the University of Arizona and co-author of a research paper titled “Status Quo: A Critical Assessment of Lifecycle Investment Advice”; and Lorne Johnson, Head of Multi-Asset Portfolio Design at PGIM Quantitative Solutions.

>> Harry Markowitz was a legendary economist, a Nobel laureate, and the father of modern portfolio theory. He is also famous for having said that diversification is the only free lunch, except that there is no record of Markowitz actually saying this. In fact, his work on the efficient frontier shows that investors give up expected return to lower their expected risk and vice versa. Diversification may be a valuable portfolio tool, but it comes at a cost, the opportunity cost, management costs, and transaction costs. In life and in investing, you don't get something for nothing. Maybe that makes diversification even more compelling. Things that are valued are not typically free, and maybe instead of having the expectation that diversification is free, we should focus on the benefit, that diversification helps us manage uncertainty. Bonds have been the most popular diversifying asset class for generations of investors seeking capital preservation, but years of ultra-low interest rates and dismal returns led investors to reach for yield in riskier corners of the bond market. Then the biggest US bond market rout arrived in 2022, and even government bonds lost over 18% in one year, so much for capital preservation. Also, in 2022, US stocks were down around the same amount, so much for diversification. Is it time for investors to reconsider how they think about diversification in their portfolios?

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To understand today's investment landscape, it's important to know how we got here. This is the OUTThinking Investor, a podcast from PGIM that examines the past, the present-day opportunities, and the future possibilities across global capital markets. Antti Ilmanen is Global Co-Head of the Portfolio Solutions Group at AQR Capital Management. His latest book is titled Investing Amid Low Expected Returns: Making the Most When Markets Offer the Least. Scott Cederburg is Associate Professor of Finance at the University of Arizona and co-author of Status Quo: A Critical Assessment of Lifecycle Investment Advice. And Lorne Johnson is Head of Multi-Asset Portfolio Design at PGIM Quantitative Solutions. Asset allocation is tricky. It requires assumptions that must be made under great uncertainty and with great consequence. That's true for an individual investor planning a 25 years or more in retirement and for an institutional investor with decreasing return expectations and increasing obligations. Diversification is the tool that most investors rely on to minimize risk of the worst outcomes. But many investors have been allocating less to diversifying assets like bonds, mostly in search of higher returns in equities. Do portfolios now have too much equity risk exposure or too little? It's no surprise that Antti Ilmanen, a well-known multi-asset investor, believes portfolios may have too much exposure to equity risk.

>> I'm a big believer in diversification. Even if you think of a 60-40 portfolio, 90% of its risk comes from equity directionality. Also, if you go 40-30-30 equities, bonds, alternatives, it's still 90% coming from equities because lots of the alternatives and actually, like, high yield bonds, for example, they've got lots of equity risk in them. So I think I'm much more pro-diversification, but I know that some observers are recommending even more, hundred percent equities if we talk of going to the level of 100% equities or the risk level of that. So that's sort of 15-20% volatility. That means that you would sometimes get 50% or worse drawdowns. Like, you know, equities had those types of drawdowns in the tech bust in early 2000s and a few years later in GFC. And such a situation, I think, raises the risk that people capitulate at the bottom. And so that danger, I think, is arguing against even more equities.

>> A recent paper by Scott Cederburg and his two co-authors had the opposite finding. Scott and his co-authors started with the premise that the most popular investment models for individuals are 60-40, stock-bond mix, and target-date funds. Target-date funds with a long horizon have heavy allocations to stocks, shifting towards more bonds as retirement approaches. The authors compared four portfolios. The first was all treasury bills, so essentially a cash portfolio. The second was a typical target-date portfolio. The third, an all-US equity portfolio, and the fourth, an all-equity portfolio, but split across US and international stocks. The first portfolio, all cash, was a washout.

>> We find that this would be a terrible strategy. You basically get no wealth accumulation, and then it doesn't really do well in capital preservation, either, if you're trying to spend anything in retirement. So we find that you basically don't generate any wealth, and then you're likely to run out of money in retirement. Relative to that, you look at the target-date funds, and they're just so much better. They generate three times as much wealth. You're much less likely to run out of money in retirement. So they're much better than bills, both in wealth accumulation and in capital preservation. So comparing to those, we can think about the two all-equity strategies. So one would be just a hundred percent domestic stocks. As expected, if you're a hundred percent in stocks, there's historically high returns on stocks. On the wealth accumulation side, your upside from being a hundred percent in stocks is going to be much, much higher than for the target-date fund that has you partially in bonds. But if you're a hundred percent in domestic stocks, you're also faced with this kind of left-tail risk. And so the bad outcomes for a hundred percent domestic stocks are much worse than the bad outcomes for the target-date fund. So then the other all-equity strategy that we consider is this 50% domestic, 50% international, where the international portion would be valuated, and we're considering all of the exchange rate. This is like a non-currency hedged international investment. What's really interesting is that it actually also offers better downside than the target-date fund. So if we look during retirement, we actually find a lower chance of running out of money if you remain all equity throughout your entire life than if you have this target-date fund that's meant for capital preservation. There's better downside protection, both in the working years and in retirement, from just remaining all equity throughout the entire life. I think it's also important here to note that we're not saying necessarily that this all-equity strategy is super, super safe.

>> A key assumption of this research is that the hypothetical investors stick with their portfolio. They avoid emotional triggers that cause many real-life investors to buy when valuations are high and sell when they're low. In reality, an all-equity portfolio could potentially lead to even more return chasing. Lorne Johnson's approach to multi-asset portfolios uses diversification as a tool to manage volatility.

>> So diversification is crucial for long-run investors. And by not diversifying, you're giving up the only free lunch in investing. Let me explain that. If you take two assets that have similar levels of volatility but have low correlation with one another, the compound return you will achieve by diversifying, by investing in those two assets, we can just say theoretically equally, you will get a higher compound return than investing in either of those assets independently. And the reason is you bring down the volatility through diversification, and you're going to have better compound returns, and that's going to come from lower drawdowns when one of those assets goes down. And if the other uncorrelated asset just doesn't go down as much, you're going to be better off than if you were just investing in one of those assets independently. Now, the most common pair that people think about are equities and bonds. And even though we've witnessed a period of positive stock-bond correlation after, let's say, a 25-year period of negative stock-bond correlation, they are still diversifying to one another and it makes sense to have both in a thoughtful diversified portfolio. Smart diversification means investing in assets that not just seem to have lower correlation all the time, but in particular, in periods of prices. So one of the things that we've done at PGIM Quantitative Solutions is to look at correlations in both expansionary periods when things are going well and also in crisis periods. And what we find in those crisis periods is that correlations go up on risky assets and you lose diversification benefit. And then there are other asset classes where the correlation can even go down or become negative. So having things in your portfolio like commodities, like real estate, those are assets that over time tend to do better inflation hedging than just equities or bonds in a portfolio.

>> But the recent long period of unusually low interest rates and inflation may have skewed investors' views of the value of diversification.

>> Twenty tens was a bad decade for many diversifiers. So whether you look at from US perspective, non-US markets, or you look at hedge funds, you look at other long-short strategies, commodities, so many diversifiers disappointed at that time. But it was exceptionally good decade for the core assets. And my theory is when I talk to investors, I say that, "If you look at that rear-view mirror, you can be hurting yourself for 2020s because it looks like the environment is now much more benign for the diversifiers. So don't give up on them now or come back to them if you did give up on them."

>> Transitioning out of a long period of low interest rates and low inflation might call for a different mindset towards what investment risk really means, particularly for investors with a long-term horizon.

>> For the most part, when bonds crash, and especially in real terms, just from an inflationary period, you just can't get it back. And so what we see is when the stock market does crash in your retirement, again, this is the worst case scenario, you're still better off just remaining in equity throughout your retirement period.

>> Complicating the diversification decision is the fact that many institutional portfolios have enjoyed a long run-up of private assets, making it difficult to reduce this exposure.

>> Private assets have had a great history. They've been great return enhancers in recent decades, but future looks much bleaker. So when you look at private equity, they used to have the advantage of much cheaper valuations than public assets. That hasn't been there for quite a while. But private equity still managed to do very well in 2010s because there was very cheap leverage. But that's gone now as well. So now, you don't have those low-hanging fruit and you still have got the very high fees that basically those managers have to beat. And I think it's going to be much harder for them to generate the outperformance that they used to. So again, great history, but not so great prospects from here. And another thing we emphasize a lot is that people take illiquidity premia too much for granted. They think, "I buy illiquids, I get a premium." And we tend to say that, "Well, it could be that that fair illiquidity premium is offset by investors liking so much the smoothness, lack of mark-to-market in private assets."

>> Given the low return forecast for risk assets, investors may need to take a different perspective when searching for the optimal multi-asset portfolio going forward.

>> We produce 10-year capital market assumptions every quarter. And the reason that we do that every quarter is any given quarter, market moves or economic developments can change those forecasts. Our forecast for US equities is a bit lower than it's been previously, and that's largely due to valuation, right? Stocks are expensive because they've gone up a lot. However, if we look outside the US, there are other opportunities for long-term investors in equities that are offering a better return. International equities, developed market, ex-US, our forecast is also largely a function of valuation. While the US market has been going gangbusters, we haven't seen that kind of performance outside the US, and hence, they look more attractive on a valuation standpoint. So there's definitely opportunities to diversify a portfolio and also to get higher return. Other good news is our fixed income forecasts are much higher than they were just a couple of years ago owing to the higher initial rates investors are going to get investing in bonds now versus where they were a couple of years ago. So what that optimal portfolio looks like is going to change based on those expected returns, changes in correlations, but investors still have an opportunity to, say, move out on the efficient frontier by diversifying across a multi-asset portfolio. And how they'll do that will evolve quarter to quarter based on our views for expected returns and volatilities. Our emerging market forecasts are also better than what we're seeing for the US. They're similar to what we're seeing for international developed markets outside the US, and that's also owing to recent underperformance and that their valuations are actually attractive.

>> Under this scenario, are we likely to see a trend away from the endowment model?

>> So endowment model relies both on equity premia and illiquidity premia, maybe also manager alpha in privates. And our empirical research suggests that the higher cash rate environment is bad for both equity and illiquids, or we get much more compressed premia in this environment. And worse, the valuations are pretty high. So I really wonder how it's possible that the valuations of US equities and some privates hasn't changed much since 2021 when we've seen this big increase in 10-year TIPS yield. So from minus 1% to over plus 2%. And that's basically the riskless part of their discount rate, and it should have some impact on valuations. So far, those have hardly budged, and I don't think that that's going to stand in the long run. Private assets have been investors' most popular source of diversification. We can debate the performance enhancement, but they certainly have lots of equity bet. I call it slow bet, that they just avoid the fast mark-to-market, but ultimately, they contain the same equity risk. Whereas, if you want true diversification, you get more of it in long-short strategies. Some of them give you even risk mitigations or trend following, and some macro strategies tend to do particularly well when you have got the worst types of persistent equity bear markets. But there is a real problem, of course, with these diversifiers. Investor patience is especially challenged with them. They are unconventional, and when they disappoint for a couple of years, it's hard for investors to stick with them. But that's maybe a reason why they will continue to provide some long-run rewards for those few investors who can stick with them. I often say that equities are forgiven a bad decade with any other strategy they tend to deallocate after two or three disappointing years.

>> But it can be difficult to stick with a strategy when it's underperforming. And it often seems like diversification breaks down when we need it most during times of crisis.

>> Some of these strategies can do quite well when most needed, but it is fair to say that there's a lot of hidden beta in many strategies which sort of shows up in those crises, and you can see that in credits or real estate and privates and some long-short strategies as well. But again, there are certainly pockets of strategies which have been reliably good in times when they were most needed. In normal times, the relationships are really modest, but then when you get real deleveraging, in those situations, you start to get more common behavior. Many hedge fund strategies or even private assets basically have to be sold in those situations.

>> For some investors, systematic or rule-based strategies may be a good option, and especially in challenging market environments.

>> We manage a suite of absolute return strategies where we believe that over time, a systematic approach can exploit both market mispricings and risk premia. So those are rules-based strategies. Our strategies are very focused on macro fundamentals when the market is pricing fundamentals. So there are periods where markets move away from fundamentals, and that's going to be a time where our rules-based strategies aren't going to perform as well. However, we're strong believers that over the long run, markets do come back to fundamentals, even if there are periods when they seem to move away, where we see outsized risks, things that are unpredictable, things that are outside of our model. That's when we want to bring the exposure to the model down, anticipating that there's going to be some turbulence. Again, moving away from the fundamentals that our systematic process is based on, if we can anticipate there's likely an environment where things are going to move away from fundamentals for a bit, that's not the time to lean into risk, that's the time to bring risk down.

>> Regardless of the strategies chosen, there are two questions in particular that institutional investors could ask themselves to help prepare for whatever the future holds.

>> I think a key question is, what's the biggest risk scenario that could damage our portfolio, and which strategies could be helpful if that risk materializes? Good question for anybody. For most investors, the answers are sustained equity market, bear market, equity market drawdowns, and then the most useful risk mitigators against those tend to be trend following and macro strategies, maybe also defensive stocks/treasuries. Our empirical analysis shows that those types of strategies have been doing very well in most of the worst bear markets for S&P 500, and they've been even better, even more reliable aids in the rare cases of private equity drawdowns, because those are, by their nature, more protracted. I think one question investors should be asking is, "Did we go too far in moving our portfolios to the rear-view mirror direction, favoring US stocks, favoring private assets, because they had such strong 2010s, and how can we step back from those positions?" And I do think that the combination of relatively high valuations, relatively high rates, and high macro volatility, they are all individually bad for those investments, and we've got that triplet right now. I may be wrong on this, but clearly, I am cautious because of those reasons on core directional risks.

>> Uncertainty remains the name of the game. Even focusing strictly on the downside can lead to higher opportunity risk if the financial markets defy gravity and continue to climb higher.

>> Markets humble us all the time, and the obvious things that, well, we've seen this quite bullish market environment, partly coming from the AI story, the lack of recession. And I think those stories can carry us through 24 and even medium term. I think the big questions for equity risk-taking, broad risk-taking is basically, "Will AI save us? Will technological advances beat the various headwinds that we get from deficits, demographics, deglobalization?" That tension is there for the next few years.

>> Strategic asset allocation is the biggest decision for an investor and probably the most crucial one, but there are also tactical views, and as difficult as it is to forecast markets and economic regimes and market sentiment, it's even more difficult to forecast geopolitical events. One example, Lorne Johnson recalls, is the eve of the US presidential election of 2016 and how investors could easily have been tripped up by the broad market sentiment.

>> The view of the portfolio management team was overwhelming that if Trump prevailed, not only would it be a big surprise, but it would be a disaster for markets. What happened that night of the election, which I was watching, so there was the New York Times meter, you know, Clinton was 90% going to win. And then as the night went on, that thing rolled down, and it was a hundred percent Trump. And yes, initially, just for a moment, the markets sold off, but then, they just took off. So that's an example. It's very hard to predict. In the presence of increased risk, geopolitical risk, for us, that's often a time when we will bring positions in that may be exposed to that risk, whether we have a view one way or the other, positive or negative, we'll bring in that view in the presence of that risk rather than leaning into a bet on a prediction.

>> But even the most risk-aware institutional investors hold cognitive biases that can lead to costly missteps. Few of us are truly cognizant of our blind spots.

>> Many investors, when they view themselves in the mirror, they see a patient contrarian investor, and yet, as my boss Cliff Asness says, they too often act like momentum investors at reversal horizons. So chasing things just when sort of mean reversal tendencies tend to dominate the three to five-year horizons. And the case in point is, of course, post-GFC decade was golden to US assets to some privates and investors are loading more, and more those into their portfolios and giving up on things that didn't do well in recent years. And I think that rear-view mirror perspective or multi-year horizons is a real danger.

>> Investment trends come and go, but without a doubt, individual and institutional investors continue to become better informed and better equipped to handle new challenges.

>> My hope is that we have a broader discussion across industry and academia on how to model these long-term returns and how we should be thinking about asset allocation for long-term investors. My guess is that it's a little bit more the outcomes of tilting the current strategies a little bit more towards equity seems more likely to me as a realistic outcome compared with everyone going out and adopting an all-equity strategy, which would then be very likely to change.

>> And hopefully, investors don't give up on diversification just before the next market downturn. Thanks to our experts, Antti Ilmanen, Scott Cederburg, and Lorne Johnson, for their insights on diversification and asset allocation models. The OUTThinking Investor is a podcast from PGIM. Follow, subscribe, and if you like what you hear, go ahead and give us a review. If you enjoyed this episode and want to hear more from PGIM, tune into our new podcast, Speaking of Alternatives.