This week's chart of the week includes an excerpt from US Colleague Bella Albrecht's analysis on whether th 60/40 portfolio is still worthwhile for investors to undertake. 

At the heart of diversification is owning investments with different performance characteristics. If one takes a big hit, something else in the portfolio goes up, or at least doesn’t fall very much. Underlying that is the concept of correlation, which measures the tendency of different investments to move up or down simultaneously. A correlation reading of 0 indicates stocks are moving with no relationship, while 1 means they see gains or losses in perfect unison. Positive readings mean direct correlations. Negative readings are known as inverse correlations.

Correlation between stocks and bonds

Over the past 20 years, stocks and bonds have been negatively correlated most of the time. However, since 2022, they’ve had strong positive correlations, which removes the diversification benefits of owning both. Dan Lefkovitz, Strategist for Morningstar Indexes, emphasises that “bonds are not a monolith,” and different types have different relationships with stocks. For example, high-yield bonds have much higher correlations with stocks than investment-grade bonds.

The correlation between short-term treasury bonds and stocks, which has a 20-year average of negative 0.12, has jumped to positive 0.51 since the start of 2022. Long-term Treasury bonds have had a positive 0.67 correlation with stocks since 2022, compared with the 20-year average of negative 0.10.

A large driver of the shift was the environment of high inflation and high yields over the past few years. “When the market expects borrowing costs to climb, correlations between stocks and bonds typically increase,” writes Amy Arnott, portfolio strategist for Morningstar Research Services. “From a mechanical perspective, cash flows are discounted by investors at higher rates, thereby decreasing the current value of stocks and bonds,” she explains. “Moreover, higher interest rates often dampen consumer and corporate spending, which can slow the economy and reduce corporate profitability.”

But many investors don’t realise correlations aren’t written in stone. “They are moving around constantly,” says Lefkovitz. “The relationship between assets is not stable.”

Stock Bond correlations

Stocks and bonds moving together can be good for investors—if both are trending upwards. Looking back, stocks and bonds have moved in the same direction in 18 of the 25 one-year periods since 2000, including 2024 to date.

For 17 of those 18 periods, stock and bond returns were positive. Comparing the returns on the S&P 500 Index and the Bloomberg US Aggregate Bond Index, 2022 was the first time since the inception of the Aggregate Bond Index in 1980 that both stocks and bonds had negative calendar-year returns.

“In the few equity market selloffs before 2022, when equity markets went down, bonds went up,” says Lefkovitz. “That’s why it was such a big surprise when bonds did not go up in 2022 when stocks went down.” During the 2020 pandemic, the 2008 market crash, and the 2002 dotcom bubble, bonds went up. “Investors got accustomed to bonds acting as a shock absorber during equity market panics and selloffs,” Lefkovitz explains.

What Should Investors Do?

Dan Lefkovitz believes that there is nothing permanent except change. He explains that in 2022, investors learned that correlations (specifically between stocks and bonds) can and do change.

However, he says diversification still holds merit for investors: “Diversification is always a sensible approach in the face of uncertainty. Portfolios should be ready for a range of scenarios. Because the future rarely resembles the past, the case for holding a broad set of assets is strong.”

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