For decades, the 60/40 stock-bond portfolio has been considered a fundamental strategy. The idea is simple: mix stocks for potential growth and bonds for stability. Since stocks and bonds often move in opposite directions, it seems like a safe bet. However, things may not be as smooth as they seem, and there are potential pitfalls to consider.
Contrary to popular perception, stock and bond returns have not always shown negative correlation. In fact, throughout much of the late 1900s, there was positive correlation. It was only during the 2000s that the correlation turned negative, leading investors to a false sense of diversification. However, in recent years, the correlation has again turned positive and has been rapidly increasing.
This matters because higher correlation means lower diversification benefits. As inflation surged, the stock-bond correlation increased for both the Euro area and US. Analysis suggests the correlation drops when inflation hovers around 2% - the sweet spot for central bank targets. With inflation outside target ranges, monetary policy expectations strengthen, altering asset valuations and increasing co-movement across markets.
The implications are as follows:
- Underestimation of portfolio risk: Relying on historical data for risk estimation may lead to larger losses because of the changing correlations between stocks and bonds.
- Increased volatility: Investors might rebalance their portfolios more aggressively due to the shifting correlations, resulting in higher volatility.
- Concentration of risky assets: Risky assets may become more concentrated among those with fewer constraints. For instance, investors aiming for better risk-adjusted returns may reduce their bond exposure.
- Dilemma for risk-averse investors: More cautious investors may need to increase their bond holdings to comply with mandates, even when bonds become less appealing as an investment option.
The typical approach of blending stocks and bonds relies on the assumption of negative correlation. However, with inflation on the rise and positive correlations in play, it's essential to rethink our portfolio strategies to match today's market dynamics. To truly diversify, let's dig into the factors that drive the movements of both stocks and bonds! Read the full article here: https://www.blackrock.com/us/individual/insights/60-40-portfolios-and-alternatives
