Do Bonds Still Help Diversify Stocks?

Investors benefit from diversification, which can smooth out the ride of a pure stock allocation.  Typically, diversification is achieved with some allocation to bonds.  These are familiar notions to most investors.  In fact, most investors take this as an axiom.  Probably the most widely used portfolio illustrating this is the 60/40 portfolio, meaning a portfolio comprised of 60% stocks and 40% bonds.  If we look at the effects of this in the last year we see that this specific portfolio strategy had the worst returns since the GFC.  How can this be?  We were led to believe that this is a strong approach to protect portfolio value through diversification in the face of market volatility, bear markets, and potential sell-offs.  However, this diversification is dependent on the mathematical relationship called correlation between stocks and bonds.

Diversification is universally regarded as the only “free lunch” on the Street meaning that it is the only investment that doesn’t cost anything and gives something back.  We attribute this statement to Nobel Memorial Prize winner in Economics Harry Markowitz, the father of Modern Portfolio Theory.  Diversification is the reason why so few firms offer one and only one product.  It pays an investor to spread out his/her bets among a pool of unrelated investments.

Stocks have always seemed like a natural foil to bonds and vice versa.  The proverbial “flight to quality” (sometimes called “flight to safety”) is based on that.  Flight to quality refers to the herd-like behavior of investors to shift out of risky assets during financial downturns or bear markets.  When risk is on, investors flock to equities.  When risk is off, people flock to bonds.  All is right with the world when this happens.  As long as equities and bonds are uncorrelated and move in different generally speaking directions all is likely fine.  The problem is that it doesn’t always happen.

As mentioned above, correlation is a common measure to gauge the relationship between stocks and bonds.  Ideally, this should be negative.  The degree to which it should be negative is as much as possible, but the reality is far from that.  In the graph above (from Bloomberg) is a plot of the correlation between stocks and bonds over time.  Any time the graph goes above the axis (GREEN), diversification becomes less likely because stocks and bonds are moving in similar directions.  If the graph says below the axis (RED), then investors are realizing the benefits of diversification since stocks are moving in opposite directions.  Below, see the historical returns of a 60/40 allocation and the correlation between stocks and bonds over the last 40 years.

Investors benefit from diversification, which can smooth out the ride of a pure stock allocation.  Typically, diversification is achieved with some allocation to bonds.  These are familiar notions to most investors.  In fact, most investors take this as an axiom.  However, this diversification is dependent on the mathematical relationship between stocks and bonds.

Diversification is universally regarded as the only “free lunch” on the Street meaning that it is the only investment that doesn’t cost anything and gives something back.  Diversification is the reason why so few firms offer one and only one product.  It pays an investor to spread out his/her bets among a pool of unrelated investments.

Stocks have always seemed like a natural foil to bonds and vice versa.  The proverbial “flight to quality” is based on that.  When risk is on, investors flock to equities.  When risk is off, people flock to equities.  All is right with the world when this happens.  The problem is that it doesn’t always happen.

Correlation is a common measure to gauge the relationship between stocks and bonds.  Ideally, this should be negative.  The degree to which it should be negative is as much as possible, but the reality is far from that.  In the graph above (from Bloomberg) is a plot of the correlation between stocks and bonds over time.  Any time the graph goes above the axis (GREEN), diversification becomes less likely because stocks and bonds are moving in opposite directions.  If the graph says below the axis (RED), then investors are realizing the benefits of diversification since stocks are moving in opposite directions.

Clearly, bonds don’t always help to diversify stocks.  Of considerable note is the later period in the graph, which is the more contemporaneous data.  The graph is clearly GREEN.  While this period of non-diversification is not the longest, this pregnant pause in the efficacy may or may not predict the end of the power of diversification of stocks and bonds or may predict a more muted effect of the diversification.

This is not scientific, so we can’t say for certain whether the is the death of the 60/40 portfolio.  That type of hyperbole, although eye catching, is not helpful.  What it probably says is that we have to be prepared for periods when stocks and bonds move in the same direction.  Bluntly said this would not be a problem for most investors if both stocks and bonds were moving up together!  it is human nature that this would garner less attention if everything was up even though it would still be a case where diversification would have been spoiled.  Correlations are not static and there is no argument why they should be!  Investors can be led astray by grounding themselves in incorrect assumptions and beliefs.  It is important to remember that things do change in the markets and that assuming things stay the same is probably one of the more deleterious preconceptions one can make.

We cannot forecast correlation with any accuracy.  What this picture should remind investors is that stocks don’t always diversify bonds and there are other ways to pursue diversification, e.g., alternatives being a prime example.  Correlations can and do change.  We attempt to compensate for that by adding more distinct asset classes to portfolios.  A dynamic market offers more opportunities to be embraced, not eschewed.

Past performance is not indicative of future results. Remember, there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investment strategies discussed in this article) will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Please remember to always speak with your individual advisor before making any investment decisions.