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Diversification myths exposed: Understand how shifting correlations between stocks and bonds impact your returns.
Were the good old days even good? Don’t worry, I am not going to blow up your great memories of the days of yore. My regulars know that I am a big fan of the “old days” when it comes to pretty much all things. I am also a big fan of cutting-edge ideas and technologies. That is why on any given day you can hear either classical music or EDM blasting in my house. The old days that I am referring to here is that “so called” 60/40 portfolio that you have heard so much about. You have probably also seen or heard many targeted adds or even quasi-academic articles about how the 60/40 portfolio is dead.
I am sure that you hear a lot about diversification in your investments. We diversify our portfolios to eliminate what’s referred to as idiosyncratic risk, or company specific risk. If you only held one stock and it came out with a surprise earnings miss, it would probably cause you a bit of grief. But if you owned several companies, the blow to your overall worth would be minimized through diversification, as the “other” portfolio holdings would not be affected by poor earnings of that single company. Makes sense right?
However, risk can also come from the market itself. The technical term for that is systematic risk, or market risk. That is captured by the old Wall Street saying, “all ships fall with the ebb tide.” In simple terms, even if all of your portfolio companies are performing well, they will all, for the most part, experience stock declines if the overall stock market is declining. So, how do you minimize the risk of that? Well, on the surface, the answer is quite simple. You spread your assets over different asset classes. For example, if the stock market is falling taking all stocks with it, good and bad, then you can minimize your overall risk by allocating to something that is not correlated to the stock market. The classical way of doing that is to invest in fixed income, or bonds, as well.
I am sure that this sounds completely logical so far, and this is exactly what most asset managers do. That is where the 60/40 portfolio came from. 60% in stocks and 40% in bonds would theoretically not only minimize losses if stocks went down, but possibly even profit. I keep using the word “theoretically” because for that to work, the two asset classes need to be inversely correlated. In simple terms, that would mean that if stocks went down, bonds would go up by the same amount. In that perfect world, gains in your bond portfolio would offset the losses from your stocks. If the relationship were truly inverse, that thesis would hold, but is it perfectly, inversely correlated? In theory, therefore, a 50/50 portfolio would never gain or lose anything. If we had a 60/40 portfolio, it would mean that stocks would be favored on the upside, but less than perfectly offset on the downside. In this world, the investor would hope that stocks would be gaining a majority of the time.
Let’s take a step back and think about why the relationship might be inversely correlated. Treasury bills, notes, and bonds are the go-to safe harbor investments when “stuff” hits the fan, because you know what you are getting, and the interest and principal payback is backed by the US Government. When that “stuff” is hitting the fan, it usually portends big declines in the stock market, for obvious reasons. Therefore, investors would sell their stocks and seek protection in the bond markets. Stocks go down, and bonds go up. If we throw in the Fed, the moves could be accentuated. If the economy falls to its knees as it famously did in the Global Financial Crisis and the COVID lockdowns, the Fed is quick to apply monetary stimulus, rate cuts, for stabilization. Lower bond yields mean higher prices for bonds. Good news if you own those 😉 when that is happening. That is the whole basis for asset class diversification and the justification for that so-called "60/40” portfolio.
If you have been involved in investing for a while, you probably already know the next chapter in this discussion. Stocks and bonds are not necessarily, always inversely related. WHAT? Sorry, not only are they not perfectly inversely correlated, their correlation changes over time. Yes! Sometimes stocks and bonds are CORELLATED. That means they both go up and down together. If they are correlated and both are going up, you may feel like an investment prodigy, but if they are both going down, you feel… um, not too great. Have a quick look at the following chart and follow me to the finish.
In the above chart, I have plotted the S&P500 and the total bond market (top panel) going back to 2007 just before the Global Financial Crisis. The larger bottom panel shows the correlation between the two asset classes. When shaded in red, it means that they are inversely correlated, and the “hedge” is working at some level. To be perfectly correlated, the number on the right axis should be -1, and you can see that it never got there. In fact, one should note that the closest that came was in 2012. But still, if you take a step back, you can see that prior to 2020, but for a few intervals, the two classes were inversely correlated more than they were correlated (more red than green 😉). After 2020, it is clear that they were more often correlated with each other. Remember that translated into better returns for a 60/40 portfolio when stocks are going up, because bonds are also going up, but painful losses when stocks are going down, because bonds are also declining. There are many plausible explanations for why suddenly since 2020 they are correlated, the best of which is that bond yields were so low leading into the pandemic, that they had nowhere to go but down. Stock investors may not have rushed out of stocks when things got rough because bond yields were not perceived as good enough; investors decided to risk staying in stocks which had more potential upside, and in some cases even higher yields.
Why am I bringing this up now. Well, folks, because we are entering into a time where bond prices will be determined not by stock investors seeking safe harbor, but rather by bond traders responding to fiscal policy, inflation, deficits, and economic performance. Therefore, a scenario where bonds are going down due to high inflation expectations and deficit-increasing policies, and stocks may be going down in response to those as well as rising bond yields. That means they will be corrected, which if you have been following me, can mean painful losses if stocks swoon. Now is the time to understand how each asset class behaves, not necessarily in relation to each other, but also on their own to the same set of stimuli.
So, what are we supposed to do with our investments. When looking at portfolio risk, one should ALWAYS allocate to target the risk level that is appropriate for oneself. Regardless of asset class. You like stocks? Great. You like bonds? Great. Just make sure you understand that any combination of those two are going to come with some level of risk, or volatility, and that that risk level works for your goals and budget. Higher volatility means that your losses can be greater at any given time. That also means that your gains could be greater at any given time. So, stocks and bonds are not always, if ever, perfectly inversely correlated. But one thing is for sure, risk and reward are, always have been, and will always be correlated. More risk, more potential return, and vice versa. Create your portfolio based on how much risk you are able to take, and not how much return you want to make. Choose wisely.
FRIDAY’S MARKETS
Stock traders decided that enough was enough and decided to buy the dip in a last-ditch effort to save Santa Claus; they managed to push stocks into the green, but it was too late to save a Santa Claus rally. A key manufacturing PMI beat economist estimates, but the number was still within the contraction zone, below 50.
NEXT UP
- S&P Global Services PMI (December) is expected to come in at 58.5, in line with the earlier, flash estimates.
- Factory Orders (November) may have slipped by 0.4 after gaining 0.2% in October.
- Later this week, we will get JOLTS Job Openings, ISM Services, FOMC Meeting Minutes, and the monthly employment number. It will be a busy week for numbers and markets will be closed on Thursday for the national day of mourning for former-President Jimmy Carter. Download the attached economic calendar for times and details.
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