We are sure that you have heard many times that “diversification is the key to performance and, therefore, wealth”. We couldn’t agree more. One thing that must be carefully considered, however, is the risk you are trying to reduce through diversification and the strategies that help you accomplish this. Diversification, at its very core, is a financial risk management concept – a diversified portfolio theoretically will have a better risk-adjusted return over the long term.
Most folks most often associate diversification with the number of stocks or industry sectors they own (we are excluding from this discussion other assets such as real estate and other “alternatives”). Today we are going to focus on asset class diversification, namely stocks and bonds.
The relationship between stocks and bonds is often viewed as inversely correlated, or when one goes up, the other goes down (as opposed to positively correlated which is when stocks and bonds move up or down at the same time). From this perspective, diversification between stocks and bonds helps reduce the volatility of the portfolio and helps reduce losses during down markets. The problem with this approach is that this inverse relationship does not always hold true.
The chart below shows the correlation between stocks and bonds over time. This chart is “smoothed” by looking at the correlation on a rolling twelve-month period and then a twelve-month moving average of these rolling periods. Note that from 1977 to 2000 stocks and bonds were positively correlated – as one moved up[down] the other moved up[down]. Then, in the 2000-2020 period, stocks and bonds were inversely correlated – as one moved up[down], the other moved down[up]. Next, look at the “current period” from 2020-2023, the relationship has become positively correlated again.
The change in relationship changes the “diversification dynamic” whereby losses in one asset class are at least partially offset by gains in the other asset class. This change must be considered when allocating across assets in order to accomplish your financial objectives.
Upon further review, we find that the correlations tilt positive when asset values are increasing, as shown in the following charts:
If we consider the periods involved, we also recognize that negative correlations tend to occur in periods of low inflation (the chart is a bit noisy, but it shows correlations fall as inflation falls, albeit with a lag):
If we accept that correlations are higher (positive) when inflation is higher, then it makes sense for correlations to have risen since 2020, when inflation bared its fangs and started to take a bite out of the economy. While all of this is well and fine, what does it mean for investors?
Simply put, asset allocation should take into account inflation expectations, as inflation influences asset class returns. If an investor believes the economy will be inflationary, he or she can reasonably expect stocks and bonds to have similar returns – directionally, which reduces the benefit of diversification. Historically speaking, an investor who believes that the outlook for equity returns is positive, and given that over time equities outperform bonds, the investor will be overweight in equities in order to capture higher returns. This does not mean, however, an investor will shun bonds, as doing so will create a significantly higher tilt in risk.
Alternatively, when an investor expects higher inflation and bonds to outperform equities, the investor will tactically (near-term) reduce their allocation to equities and increase their allocation to bonds.
While analyzing correlation may seem to be the purview of academics and strategy geeks (yes, we accept that and wear the badge with pride), investors should understand its influence on asset allocation in order to best accomplish their financial goals and to work with their advisor on an investment response to periods of higher inflation.
The views stated in this blog (report) are not necessarily the opinion of Cetera Advisors LLC. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed.