Harvesting Opportunity: Navigating the New Era of Investing

Autumn is in the air. With cool mornings, turning leaves, and for those of us in the Midwest, harvesters lining the fields to reap the yield of farmers’ hard-earned crops. As we enter the final three months of the year, we too have been at work, rebalancing portfolios to harvest the returns of another strong market season.

As the seasons change, we are reminded of the parallel rhythm this time of year brings to investing. In this post, we will discuss how changes at the largest institutions in the economy have affected the post-COVID era of investing, and how failing to proactively adapt to these shifts could leave a traditional portfolio ill-equipped to weather the future.

What happened to the traditional “60/40”?

It has been roughly four years since the historic market shifts of 2022 began, and most of us vividly remember the challenges of that year, as both stocks and bonds fell by double digits for the first time in over 40 years. The widely popular, middle-of-the-road 60% stock and 40% bond portfolio posted its worst calendar-year performance on record, dropping roughly 16%. Fundamentally, the $7 trillion in fiscal and monetary stimulus that drove the post-COVID boom eventually caught up with markets, forcing interest rates to spike to account for the massive increase in the money supply. Four years later, the rate of acceleration in interest rates has slowed, but the trajectory continues to grind upward. As we navigate an interest rate environment that has surpassed 20-year highs, the question on many investors’ minds is, “Are bonds a faulty investment tool for the defensive portion of my portfolio?”

Won’t be fooled again

For as technical as the world of investments can be, what we’ve learned over our firm’s 30-plus years of history is that being a student of the market means understanding the human element of decision-making. Behavioral biases come in many forms, and they can greatly impact both individual investors and the broader market. One of the most prevalent biases we see today regarding the bond market is Extrapolation Bias—when investors assume that current trends will continue indefinitely into the future. Because of the pain experienced over the last four years, it is tempting to shun this area of the market altogether as “broken.” While that lack of performance had real consequences, our job is to set aside emotion and make an honest, objective assessment of any investment opportunity.

Diversification is a Hedge Against Uncertainty

If you have been with us for more than a few years, you know we have had the fortunate discernment to temporarily distance ourselves from bonds, limiting their weighting in favor of alternative investments and a modest equity overweight. After what we have witnessed recently, we believe that while it is too early to claim the “bond winter” is over, we are seeing sprouts of real investment opportunity forming in fixed income. As such, we have decided to gradually increase our bond exposure while maintaining a modest underweight.

The reason for this change is rooted in the fundamental opportunity embedded in today’s yields. A bond’s return is driven by two components: inflation expectations and “real yield.” That real yield is now at over 20-year highs. Speculation persists on exactly what is driving this, but a primary argument is the massive capital investment in Artificial Intelligence and its potential to drive future economic growth. We are tremendous fans of the technological revolution unfolding before our eyes and believe it will fundamentally change our lives. However, from an investment standpoint, we must honestly assess the risks of any potential shortfall or slowdown in the pace of AI adoption. Should a roadblock appear, the upward pressure on interest rates could cave, allowing bonds to step back in and serve as a powerful hedge against equities.

Alongside bonds, we hold firm in the belief that the only true “free lunch” in investing is diversification, which modern portfolio theory claims is the only way to achieve similar or better returns with lower risk. By diversifying our bets across uncorrelated alternative asset classes, we continually strive to deliver better outcomes for our clients through prudent asset allocation.

History has proven that in a society that enables innovation and applauds ingenuity, breakthroughs will happen, and mankind will be better off for it. However, we will continue to prepare for the unknowns, balancing our excitement for the future with disciplined diversification, even if it means straying from consensus and human emotion.