What You Need to Know About Asset Allocation (With Sebastien Page)

KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders. 

KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week we analyze what's happening in the markets and discuss how it might affect your investments.

Well, hello, Liz Ann. I don't think we've seen each other in person now for a little while. But this week, big earnings reports from the big tech companies. And as Kevin mentioned last week on the podcast, talking about sectors, the tech sector is really top-heavy. So how much do these four or five companies sway the market overall?

LIZ ANN: Well, it's a lot. In fact, the moniker being used more recently has been the Magnificent Seven, even though arguably two of the members, Apple and Tesla, which have not done well, are being considered as maybe not in that group. And that's why you're hearing terms like the Fab Five or Fab Four, but the seven represents almost 30% of the S&P 500®. So it can have a big impact. But of course, it can have a big impact in both directions. 2023 was a year where they dominated performance. So it provided a huge lift to the cap-weighted indexes like the S&P 500 and the NASDAQ. But part of the reason why we had the recent pullback in the S&P and the NASDAQ was because of some weakness in those names, so it does work in both directions. I think we have to continue to be mindful of concentration risks. I mean, the earnings profiles have been very strong, maybe with the exception of Tesla, but one could argue as we look ahead to the rest of this year that the bar has been set high. And you know what I always like to say as it relates to, whether it's earnings data or economic data and how the market reacts, better or worse often matters more than good or bad, and that relates to where the expectation bar is set. 

So we continue to think, as Kevin discussed in our recent episode, that although we have tech rated marketperform, we think the better opportunities are in the more classic cyclicals like financials, energy, and materials. So what about you, Kathy?

Bond investors have had an entirely different experience, at least in the past month or so. So what's your thinking lately about action in the bond market and Treasury yields in particular?

KATHY: Well, yields in general keep moving up, but they're also just bouncing around in kind of a random way. And I think a lot of that has to do with just this uncertainty about what the Fed will do, when they'll do it, if they'll do it, and when we could possibly expect them to do something. So the latest pricing in the market is for two rate cuts of 25 basis points each this year. Now that's a huge swing from where we were earlier this year when the market was pricing in six or seven rate cuts, but it's also consistent with what the Fed has been signaling. But overall, it has been a little bit calmer in the past week or so. We've had the quiet period ahead of the next Fed meeting, April 30th and May 1st, and that always gives us a little bit of a respite from this constant barrage of information that the market tries to sort through.

Credit spreads have been tight, stayed tight, so obviously there's no concern in the bond market there. So we're all kind of on hold waiting for the next slew of data on the next Fed meeting. 

Liz Ann, you are speaking with Sébastien Page today from T. Rowe Price, big in the asset allocation area. What is his take on the economy?

LIZ ANN: Yeah, we had a great conversation that covered a lot of different areas, but I would say a theme related to both his take on the economy and market behavior is around liquidity and still ample liquidity and that has been a big support for the consumer and overall consumption trends, but it also ties into why he thinks that inflation is probably going to remain somewhat elevated, not surge higher again, but it could take a bit of time before it gets down to the Fed's target, and it has a lot to do with the liquidity story. So that was one of many interesting sort of threads and topics we covered. So I hope everybody enjoys it.

Joining me now is Sébastien Page. Sébastien is head of global multi-asset and chief investment officer at T. Rowe Price. He is a member of their asset allocation committee, which is responsible for tactical investment decisions across asset allocation portfolios. And Sébastien's also a member of the management committee of T. Rowe Price Group. Prior to T. Rowe Price, Sébastien worked for PIMCO as an executive vice president, where he led a team focused on research and development of multi-asset solutions. He was also a senior managing director at State Street Global Markets. He is a regular guest in the financial media across the spectrum, including Bloomberg TV and CNBC, and was recently named among the 15 top voices in finance for 2022 by LinkedIn. 

Sébastien, thank you so much for joining the podcast. You and I have shared the actual stage together on a couple of occasions, but this is the first time doing it in podcast format, but I just want to say how much we appreciate you joining us, so thanks for coming on.

SÉBASTIEN: Thank you. Thanks for inviting me. I love podcasts. I feel like I don't do enough, so I'm excited.

LIZ ANN: I love them too, and I actually love being able to be the question asker, because in my field of work, I'm often the question answerer. So thank you for letting me turn the tables on you. Well, in addition to your many accomplishments, which we touched on in your bio, you're also the author of a book titled Beyond Diversification: What Every Investor Needs to Know About Asset Allocation, published by McGraw Hill, and we will have a link to that in the show notes. I want to ask you about the book and what prompted you to write it, but I'm also fascinated by anybody that can find the time when they actually have a day job to write a book. I get asked to do it often. I can't fathom having the time. So where did you find the time? And tell us a little bit about the book.

SÉBASTIEN: Liz Ann, I'll be happy to be your writing coach and help you in the process. Let me start with the book. Think about it as how the pros do asset allocation. It's a summary of everything I've learned in my career. It goes through the cutting edge in the research on how to do asset allocation. There are three sections: building expected returns, estimating risk, and then portfolio construction. So it's not a very technical book, but you need to have some basic knowledge of asset allocation and finance. And if you're just interested in the practical aspect of it, because I had a couple reviews, Liz Ann, that hurt my feelings. The reviews were really good, but a couple were, "Well, this is a bit more technical," so people that picked up the book with sort of zero knowledge of finance.

You can do that. You can pick up the book, go to the third section. There's a bunch of model portfolios there that help with directly your asset allocation decisions. And then if you're interested in how we do that, how we come to those asset allocations, then the rest of the book will be useful to you. Liz Ann, on how to write? It's all a matter of doing a little bit at a time consistently.

And I can tell you my routine, it's Saturday mornings, two to three hours, and then maybe an hour or two more on Sundays. That's all I do. And if you do this every week, within a year, year and a half, you'll have a book. Just don't skip a week, just keep going, keep writing. I set my goal as at 800 to 1,000 words, and that's it. That's all you need.

LIZ ANN: So it was about a year-and-a-half-long process? 

SÉBASTIEN: Yeah, then there's editing, and there's a process with the production of the book. But that's pretty much it. Just a little bit every weekend.

LIZ ANN: That kind of topic is evergreen in nature. You're not talking about current valuations in the market right now or what happened in the past couple of weeks. So it's got shelf life. So I applaud tackling the topic. And it's been an area I've been in really my whole career, the whole idea of asset allocation. And so I want to ask you a few questions on that. We've been doing a lot of work recently on the correlation between stocks and bonds, and I tend to focus on it as a yields-versus-stocks analysis and the changing environment relative to the period, the so-called "great moderation" period. So what are your thoughts on the shifts in the relationship between bond yields and stocks and how investors approach that relationship between those two major asset classes and portfolios?

SÉBASTIEN: Yeah, I love that question. I'm going to start, Liz Ann, by saying something that's not controversial and probably not useful, somewhat obvious. The stock-bond correlation is highly unstable. If you go back 80 years, it has ranged on a 12-month basis from minus 80% to plus 80%. It has flipped sign over 30 times.

So when I did the research on it, our goal was to explain it, try to understand what drives a positive stock-bond correlation and what drives a negative stock-bond correlation. And the punchline is what we saw in 2022, but as you know, we saw that in the '70s as well. When you get an inflation shock, both stocks and bonds can go down together, and the correlation turns positive, and people start questioning the 60-40. But what is still true, and why I think bonds still have a role in investors' portfolios, is that when you get a growth shock, and recently we're seeing some geopolitical uncertainty, for example, but those types of shocks, bonds remain the flight to safety. So the nemesis of bonds is the inflation shock.

LIZ ANN: So Sébastien, I want to ask you about how to deal with fat tails in portfolio construction. And one of the ways to think about fat tails, for those that don't know, is if you think of a distribution chart of outcomes, there's the maybe easy-to-plan-for obvious outcomes, but then there are tail risks on either side, either extreme risks on the negative end of the spectrum or on the positive end of the spectrum that don't have a high probability, but is something that we have to be mindful of.

SÉBASTIEN: In two ways. First, I think as an industry, when advisors work with individuals, we do look at fat tails. We know that there are some rare events where the losses will be much greater than you would expect using traditional models and assumptions. We know that markets can go berserk. That's a technical term, Liz Ann, "berserk."

We know that markets can drop, especially during a liquidity crisis, for example. And the way to deal with this in asset allocation is to understand what happens. We call it stress testing. And we all do it. And if you're an individual and you work with an advisor, they've probably, a good one, they've probably stress tested your portfolio. And you just need to think about what is high-yield bonds going to do in a stress event, not on average, because averages are misleading. I still think as an industry though, we don't pay enough attention to it. For individuals nowadays, they're getting introduced more and more to private asset classes or risk factors. I know, Liz Ann, you've talked about risk factors. A lot of those strategies, they're sometimes really attractive from a month-to-month volatility perspective, but they might actually have some fat tails. And I'm speaking sort of generally, right? But let me give you a quick example. Andrew Lo is a professor at MIT. He wrote a paper back in 2001. And it is a fancy title. It is a paper about hedge-fund risk. And the title was "Capital Decimation Partners."

So you kind of know what the paper is going to be about. It's about risk management and fat tails and hedge funds. And what he showed was that without any investment skill, any foresight, he was able to double the Sharpe ratio, the risk-adjusted return of the S&P 500 through the '90s for a long period of time. The question, Liz Ann, you said you like asking questions and you like turning the tables. I'll turn the tables just once here.

What was the strategy? How do you double a Sharpe ratio without any skill?

LIZ ANN: I have no idea.

SÉBASTIEN: He was selling insurance. The strategy was to naively load up on tail risk. It was to sell protections, sell put options on the market. As long as the market doesn't crash, you get a little bit of a positive return from selling the options. It's literally like selling insurance. But then when there's a fat tail, the strategy blows up. So it's misleading to look at a very high Sharpe ratio when you're selling insurance. Why do I say that?

Because a lot of factor strategies or even private assets, if you think about it, they're selling a liquidity option. It doesn't mean you don't want to invest in those. It just means you need to use your stress tests accordingly in the portfolio-construction stage, not at the end. Because a lot of asset allocators, Liz Ann, they build their asset mix, and then they run the stress test after. And they go, "Oh, that looks fine. That's OK," but what's even better is to bring this stress testing and the notion of tail risk to the portfolio construction process itself.

LIZ ANN: And Sébastien, you mentioned liquidity shocks. I want to continue on the subject of liquidity but ask a question more broadly in terms of the power and importance of liquidity, not just in driving the markets these days, but also in driving the economy and particularly areas like consumption. So share your thoughts on the role of liquidity in this cycle.

SÉBASTIEN: Look, in this cycle, I call it the blob of money. We've deployed 20 trillion in stimulus across monetary and fiscal globally. And that blob of money keeps eating all those negative headlines. You know what I'm talking about, The Blob movie? It's an old movie, but it's this liquidity that's been out there. And we saw how extreme it got in 2021 when there's so much liquidity and excess savings to invest that people would pay a million dollars for an NFT, a picture of a rock. That's when you start seeing the speculation in the markets. So liquidity has been a huge factor because if you think about it, let's travel back in time to the end of 2021 when inflation is going higher and higher, but Russia has not invaded Ukraine yet and markets have been really good in '21.

Let's say we travel back in time, and as a thought experiment, let's take all our listeners on a thought experiment. Imagine that you buy protection because you think stocks are going to go down, a so-called put option. And it's the beginning of '22. And you fall into a coma. And you're just waking up. And you're asking Liz Ann and I, you're asking us, "What's happened?" And I say, well, "Russia invaded Ukraine. There's still a hot war in Europe. The Fed has hiked by 550 basis points. We've had the number two, number three, number four largest bank failures in history. Oh, and by the way, there's another war now in the Middle East." You would think stocks would be down. They're not. The S&P's up since then. And part of it has been this blob of money, all this liquidity in the system. We still have 7 trillion in money market funds, 4, 5 trillion in checkable deposits. So that's the sort of risk-seeking side of excess liquidity. The other side of it—I'm sorry I'm giving a long answer; I'll make my answers a bit shorter—but liquidity is really important because we don't think about it in normal times. And so the other side of it for liquidity is that when things get bad, they can get bad really quickly in markets.

So my father, Liz Ann, was a finance professor, and I actually took two of his classes. And that's probably a discussion for another podcast. But he loved to use analogy. And this is how he would describe a liquidity crisis to the students. He was talking about financial markets, right? So he would say, "Imagine that the building is on fire."

Of course, everyone is going to be rushing for the door at the same time. But then he would say, "The difference in financial markets is that in order to get out of the building, you need to find someone to take your place in the building." And what he meant by that is if you're holding an illiquid asset, an illiquid bond, or a piece of commercial real estate, you're not going to be able to sell it until you find a buyer. And that's the nature, the fundamental nature of liquidity crises. And that's why a lot of assets that typically don't behave together start behaving together. That's why you're seeing gaps in prices, in asset prices, during those rare but devastating liquidity crises events. And that's why we tell investors that they shouldn't just load up on illiquid assets in their portfolios.

LIZ ANN: I want to ask you specifically about the, I think the latest is $6.1 or $6.2 trillion in money market funds and the debate that's ongoing about how sticky that money is. Some view it as some maybe not imminent but eventual source of massive additional liquidity that will go into the equity market. I have some sympathy with the idea that after a long period of, you know, ZIRP, or zero interest rate policy, that maybe not all of it, but some of that money, is perfectly comfortable sitting there and earning a decent yield. And I'm going to transition into your view sort of on the stock market, but I want to start with that, with your views on that particular subject of, is this, should this be seen as eventual fuel for the equity market, or should we view it as distinct from that?

SÉBASTIEN: I love that question. It is a bit controversial. People talk of cash on the sidelines. And I can tell, Liz Ann, by the way you're asking the question, that you're somewhat skeptical that this provides fuel to push equities ever higher. I agree with you. You can, for example, adjust the size of that cash buffer or cash on the sidelines for the size of the market, and it's not that high, right? Because markets are up as well. And to your point, what's the expression? "T-bill and chill?" You know, you're getting 5% on T-bills. That's pretty neat with very little risk. So I think that is not a given. However, where I have a different view from the majority is this idea that we've run out.

You know, a lot of economists have said we're running out of excess savings. And that is correct if you adjust for trend savings, if you adjust for inflation, if you adjust for additional debt that individuals have taken. However, that's a lot of adjustments, Liz Ann. The data is the data, the raw data. And Bank of America just a few weeks ago said, "Look, we have 37 million customers. Their checking account balance on average is 40% higher than their 2019 levels." And they said, "By the way, that's across pretty much all income levels." The $6.1 trillion in money markets is still $6.1 trillion. And then there's separate data on checkable deposits that shows they're up about $3 trillion since 2019.

Yeah, it's a nuanced answer. I think this idea of cash on the sidelines as rocket fuel for ever-higher stock market, I don't buy it. I don't think you buy it. Didn't sound like you're buying it in your question. 

LIZ ANN: Correct

SÉBASTIEN: But there is liquidity there. And it might stay there as long as rates stay high.

LIZ ANN: Let's hone in on the stock market a little bit. One of the most enjoyable note that I got from you in advance of having this conversation was "I'm very enthusiastically, with lots of conviction, aggressively neutral between stocks and bonds." So expand on that and what it means for the average individual investor out there.

SÉBASTIEN: Yeah, and let me tell you how I came up with that description. You know, Liz Ann, I see you a lot on CNBC. You always do great. I go on CNBC sometimes as well. You know how it works is you send some notes, and they ignore them. 

LIZ ANN: Completely.

SÉBASTIEN: And they ask you whatever they want to ask you about that day. But this one time in '23, I sent this note, and I had this little comment there that said, "I'm reluctantly bearish." Everyone was bearish on the economy, but I was reluctant. Because first of all, I don't like being bearish on stocks. I like stocks for the long run. And they started calling me the Reluctant Bear. And I was the Reluctant Bear for a while. And I'm trying to shed. It's like in kindergarten. You get a nickname. The more you push back on the nickname, the more it sticks.

SÉBASTIEN: So my notes to CNBC for a little while now have been, "I'm very enthusiastically, with lots of conviction, aggressively neutral between stocks and bonds." And here's the main reason. I think this is an environment where investors should not panic and go all the way to cash, and investors should not either just load up on stocks, especially if it doesn't correspond to how much risk they normally take. So my point is more about "Believe in your strategic asset allocation." There's so much work that goes into it. Even as an individual, you have to really think hard about how much stocks you're willing to have in your savings versus bonds. That's a really important decision for your long-time financial planning. And we have these life-cycle models that tell you, based on your age, what your strategic allocations would be. All this work, maybe you work with an advisor who's doing a lot of work for you on that. I think just stick to that for now, your risk tolerance. And by the way, that might mean more stocks than people think. I talk about this in my book. I have a life-cycle investing model there. I'm 47 years old. That means, you know, if I do OK, I'll still be working for 15, 20 years.

I don't think I'll ever stop working …

LIZ ANN: Ditto.

SÉBASTIEN: But officially "working." And then another, if I stay healthy, another 30 years in retirement. Why would I own a lot of bonds at that point in my life? So I'm actually in my personal savings, right, 85% in stocks.

LIZ ANN: I think though what's important, and this is how I often instruct investors if they're asking about allocation, I think one of the mistakes that investors make is they tie risk tolerance solely to age. And I think the more relevant assessment is whether there's a wide or narrow gap between your financial risk tolerance, which may indeed be tied to time horizon associated with age, and your emotional risk tolerance. And it's the emotional side of things that usually gets people in trouble. But I completely agree with your thinking, especially with regard to the unfortunate "get in, get out" mentality that is often fostered by the financial media, and I often say, neither get in nor get out, if it's all or nothing, is an investing strategy. All that is gambling on actually two moments in time, not even one moment in time, and investing should be a disciplined process over time. And it brings up another subject on which I know you have a lot of passion, I do personally, Schwab as a company does, which is financial literacy. So talk about the why behind your passion for financial literacy, and I know I'm sure you think we should be doing more in terms of lessons associated with that.

SÉBASTIEN: I'm so happy you're asking about that. Look, we talked about my book earlier, and I said a couple of reviews hurt my feelings. And that's kind of how this came about is during the pandemic. Again, the reviews were really good, but a couple of them is like one star, "This book is too complex," right? And that's because you kind of need a basic level of financial sort of knowledge to enjoy it and follow what I'm writing about.

It made me think hard about my communication style and how I talk about finance and complicated concepts. And my daughter was 10 years old at the time, and she happened to be there. So I had this idea. I said, well, they don't teach this in high school at all, or middle school or …

LIZ ANN: It's a travesty.

SÉBASTIEN: And I think they should, you know? They should at least teach the basics of money. And so she was there, and I thought, "OK as a financial expert, as a suit-wearing CNBC financial expert, can I explain to my daughter what is an interest rate?" She's 10 years old, right? And what is the time value of money, right? I ended up asking her, "Do you want a puppy right now or a puppy a year from now?" And she said, "Well, I want a puppy right now." So we got into the time value of money. Then we got into interest rates. And then the video that kind of went viral on LinkedIn was when I walked her through the difference between saving throughout your lifetime, putting money under the mattress, versus investing and benefiting from compound interest. And there's this moment where her eyes light up, and it's like, "This is unbelievable." I can retire with a million dollars on a just very basic salary if I just save consistently and get a rate of return on it.

It was well received, and I just got more and more into it. We created a series of videos. They're out there on LinkedIn. And what I would say is, look, I got this award from LinkedIn for a top voice in finance, and I was really happy. I started reading the award announcement, and it was all about the financial literacy. Nothing about all the financial expertise I post like three, four times a week. So I showed this to my daughter, and Liz Ann, she wanted me for this podcast to remind and tell everybody that it's her award, that it has nothing to do with my financial expertise. Now she's 13. We might do more financial literacy, educational videos, because there's demand. But the last time I asked, she said, "Dad, I'm 13. It's not as cute anymore." So I'm not sure I'll get her to do it.

LIZ ANN: But it's still so necessary. I went through the same thing. I made myself such a pest with the principal of my kids' high school in Connecticut throughout the eight years that they were combined there saying, "Why don't we have a financial literacy course?" And her answer was always, "Well, Liz Ann, we have a stock picking club." I said, "That's not what I'm talking about. I'm talking about the basics," and doing it in a way, to your point, that anyone can understand. And everyone benefits from it. So I'm always thrilled when I find somebody else in this business that does have to live their life talking about very complicated subjects that this is one of your passions, because I think it is so important for any of us that have that voice and have listeners and readers to do that, so kudos to you.

And I'm going to dive a little more on what you did on LinkedIn, but it's much appreciated. 

SÉBASTIEN: Thank you. 

LIZ ANN: And also thank you so much for coming on. I love our conversations. I wish we could do them more often. We love having you on the show. Hope to have you back, but we really appreciate your time.

SÉBASTIEN: Thank you. Thanks, everybody.

KATHY: Liz Ann, that was great. Now what's on your radar for next week? I'm sure we've got a lot of economic data and a lot of earnings, right?

LIZ ANN: We sure do. We are right in the meat of earnings season right now, and it's an environment where every single day you get more news, the data changes in terms of something they call the blended growth rate, which is the combination of companies that have already reported earnings, their actual results with the consensus estimates. And I continue to think that just as important as the reports for the prior quarter are the outlooks, so that's what I'll be keeping a close eye on. And then you're right, a ton of economic data next week. There's a slew of housing-related data, and that's been particularly interesting lately because of swings in Treasury yields and what it means for the mortgage market. We get the Conference Board version of consumer confidence. Interesting backdrop there. It's a monthly reading like consumer sentiment, but consumer confidence tends to be biased more by what's going on in the labor market, whereas consumer sentiment put out by University of Michigan tends to be biased more by what's going on in inflation. So we'll have to see whether there's a spread between those two as well. We get the ADP version of jobs. Of course, at the end of the week, we get the big jobs report. We've got ISM manufacturing coming out. The S&P global version of the PMIs were weaker than expected, both on the manufacturing and services side. But ISM is more widely watched, so that'll be interesting. Of course we've got the FOMC meeting.

I know, Kathy, you're writing the commentary, you and I tag team on that. So I don't think we're expecting much in terms of any change to interest rates. But these days, the press conferences are always very interesting. So what about you, aside from being the woman behind the pen writing the commentary? What are your thoughts on next week and what we might hear from Powell?

KATHY: Yeah, the Fed meeting, as you said, I don't think that there'll be any indication of a change in policy that's imminent. I think, Powell, you know, the statement should acknowledge, if it reflects the Beige Book, that things are moving, you know, moderately on the economy, that it's doing well, but in the Beige Book, there were five times as many references to the economy growing slightly or modestly as growing strongly.

So I think the statement will reflect that, continued moderate growth. Any reference to what they're seeing on inflation will be important, but I don't think they'll put any big surprises in there. I think Powell will probably try to stick with the party line that patience is the word of the day, that they'll just wait and look for inflation to moderate from here, and once they're confident it's moving towards 2%, then there's a timing of rate cuts will come up. But right now, I think patience will be the big messaging there. I will be looking at not only all the numbers that you mentioned, particularly the jobs report, of course, but the JOLTS numbers, this job openings numbers, because there's a component there called the quits rate, number of people voluntarily leaving their jobs, which has correlated with wage gains and with inflation in this cycle. So I'll be kind of keying in on that because that may be a very interesting reading on what we can expect down the road. But yeah, busy week. Lots of information for us to absorb, and I imagine this nice quiet period that we've enjoyed will come to an end.

LIZ ANN: Well, that's it for us this week. As always, thanks for listening. And remember, you can follow us on social media. I'm @LizAnnSonders on X and LinkedIn. By the way, those are the only two social media platforms I am active on. So if you see anything looking like me, sounding like me, figuratively, on Instagram or Facebook or WhatsApp or Threads, especially some miraculous stock-picking club I apparently have, that is not me. So don't follow them.

Don't reach out to me on the other platform and saying, "Hey, can I get into this club?" They are all scams. We're doing our best to take them down, but I am only active on X and LinkedIn. 

KATHY: I'm @KathyJones. That's Kathy with a K on X, formerly known as Twitter, and LinkedIn. I have a few imposters, but not nearly as many as you, Liz Ann, so it's a less of an issue.

Be sure to follow us for free in your favorite podcast app, and if you've enjoyed this episode, tell a friend about the show or leave us a rating or review on Apple Podcasts. And thanks to everyone who's left us feedback on Spotify. We do enjoy seeing those comments.

For important disclosures, see the show notes or schwab.com/OnInvesting.