In Defense of a Balanced Portfolio of Stocks and Bonds.
“If the financial system has a defect, it is that it reflects and magnifies what we human beings are like. Money amplifies our tendency to overreact, to swing from exuberance when things are going well to deep depression when they go wrong. Booms and busts are products, at root, of our emotional volatility.”
― Niall Ferguson
One reason this argument has gained steam in recent months is the positive correlation between stocks and bonds in 2022. Now both stocks and bonds posted negative returns in 2022, but the correlation between the two asset classes was positive because they were both moving in the same direction. The idea of correlation is an important concept in portfolio diversification.
Forgive me for the college finance lecture, but before we examine this relationship more closely it is important to start by defining correlation which is measured by a figure known as the correlation coefficient. The definition of correlation coefficient according to the CFA Institute is “a number between −1 and +1 that measures the consistency or tendency for two investments to act in a similar way. It is used to determine the effect on portfolio risk when two assets are combined.”[i] I think of it as the degree to which to investments have historically moved together. To grossly oversimplify this, a -1 means a perfectly negative correlation (+5% in investment A correlates to -5% in investment B), a +1 means a perfectly positive correlation (+5% in investment A correlates to +5% in investment B), and a 0 means no linear relationship between investments A and B.
The goal of diversification is to build a portfolio of assets that are not perfectly positively correlated. If all the assets owned in a portfolio are perfectly positively correlated, then there is no diversification benefit from owning multiple assets. If all your assets are always up or down by the same amount, there is no smoothing effect of the ups and downs of the market. An example of this relationship in recent history is cryptocurrencies like Bitcoin and Ethereum which had a +0.97 correlation coefficient from 2016-2022. Essentially, Ethereum and Bitcoin have moved roughly in tandem and have not provided a diversification benefit to one another during that period. Let’s examine some numbers related to stocks and bonds to make this more concrete.
Using data on historical asset class returns provided by Portfolio Visualizer[ii] we can examine the historical relationship between US stocks and bonds. For simplicity I will refer to the Total US Stock Market as “stocks” and the Total US Bond Market as “bonds”.[iii] In 2022, the calendar year return for stocks was -19.60% and for bonds was -13.25%. This means that bonds did provide a diversification factor as a 60/40 portfolio would have been down -17.06%, approximately 2.5% less than a pure stock portfolio. This is probably small comfort to an investor who “only” lost 17% portfolio value compared to almost 20%. However, one year does not a pattern make, and stock and bond investors should really have a time horizon of at least 3 years, so let’s look beyond 2022. If we examine annual returns from 1987-2022, there have been 8 years in which stocks posted negative returns and, of those 8 years, bonds were also negative in only 3 of them. This means that bonds were pulling the 60/40 portfolio up roughly two thirds of those negative years for stocks. The average return for a pure stock portfolio in those 8 years was -13.83% whereas bonds were +3.22% and the 60/40 portfolio in those same years averaged -7.01%. On the flip side, there were a total of 6 years during the same period when bonds posted negative returns. Of those 6 years, stocks were also negative in 3 of them. The average return for a pure stock portfolio in those 6 years was +9.62%, bonds were -3.47%, and the 60/40 portfolio averaged +4.38%. The chart below shows the 11 years in which either stocks or bonds have posted a negative return and the performance of the 60/40 portfolio in those years. As you can see, stocks have historically had larger swings than bonds and have set the tone for the 60/40 portfolio for that year. However, the diversification benefit provided by bonds smoothed out the volatility and the 60/40 portfolio returns were always closer to the center line than stocks. In 1990, 2000-2002, and 2008 the inverse relationship between stocks and bonds was favorable for the 60/40 portfolio.
Stock and Bond Returns in Negative Years
The correlation coefficient for stocks and bonds from 1987 – 2022 was approximately +0.28 which means that stocks and bonds historically have had a weak positive correlation. However, portfolio diversification can be achieved without negative correlation, and long-term investors investing in growth assets may, in fact, want weak positive correlation. Let’s say an investor is investing for growth over the long term and owns only two assets (A and B) in roughly equal parts. Let’s also assume there is a
strong negative correlation between A and B. This would mean that in periods in which A posts a positive return, we would expect B to post a negative return and vice versa. This negative correlation would wash out returns over time for this investor. While stocks and bonds have had a positive correlation from 1987-2022, this has meant that investors with a diversified portfolio of stocks and bonds have enjoyed 25 of 36 years (roughly 70% of the time) in which both components of their portfolio have experienced positive returns. There were also only 3 years in which both stocks and bonds posted negative returns (less than 9% of the time). This has added up to a +9.02% average annual return for the 60/40 portfolio from 1987-2022. We can visualize this relationship with the chart below which shows bonds generally plugging along on a slow upward trajectory even when the stock market was experiencing significant volatility.
Total US Stock and Bond Markets
It is clear from both graphics that 2022 was an historically unusual period for the relationship between stocks and bonds and the worst bond performance in our observation period. This is largely due to the unusually low interest rates the economy has experienced since the Global Financial Crisis. The decade of near-zero interest rates made borrowing inexpensive and provided a tailwind to stocks while building up a market of low-yielding bonds. The Effective Federal Funds Rate has increased by 4.75% in just 12 months. As we have discussed before, rising interest rates push down the price of existing lower rate bonds as attractive new bonds paying higher interest enter the market.
Effective Federal Funds Rate
The positive news for long-term investors with a diversified portfolio of stocks and bonds is that the current higher rates have made bonds much more attractive. As bonds have rolled off in client portfolios, new bonds have been purchased that are paying more
interest. The Federal Reserve may be nearing peak interest rates and has stated an intent to hold those rates higher for longer. While a “higher for longer” environment may not be as conducive to strong growth in stocks as the last decade of near-zero interest rates, it does mean a sustained window to lock in higher bond rates. If interest rates fall, bond prices will climb. If the US economy does enter a recession, it is possible that stock prices may fall. However, interest rates are now at a level at which bonds may ballast a portfolio as they did in 2000-2002 and 2008. Further, stocks already pared the high valuations of 2020-2021 and the P/E ratio of the S&P 500 is roughly in line with the historical average.
S&P 500 P/E Ratio
Although 2022 was a difficult year and there is still plenty of uncertainty in the markets, traditional stock and bond investments have been long-term winners for investors. As the opening quote from Niall Ferguson indicates, money is an emotional thing. It is easy to invest when things are going well, and it can be an incredible struggle to hold course when things look scary. But often the difference between successful and regretful investors is that successful investors make a well-devised plan and stick to it, adjusting thoughtfully and not out of emotion. There are always tail risks. There are always unexpected shocks to the system. And yet traditional investment assets have stood the test of time over and over again.
i CFA Program Glossary (cfainstitute.org)
ii Asset Class Returns (portfoliovisualizer.com)
iii Total US Bond Market represented by the Vanguard Total Bond Market Index Fund (VBMFX) 1987 – 2022. Total US Stock Market represented by the Vanguard Total Stock Market Index Fund (VTSMX) 1993-2022 and the AQR US MKT Factor Returns from 1987 – 1992.