I’ll confess to being a bit concerned by the ongoing incredulity exhibited by stewards of capital at the prospect of a positive stock-bond return correlation.
While acknowledging that you have to be fairly “old” to remember a time when building a diversified portfolio with uncorrelated assets actually required a modicum of skill and creativity, things that seem too good to be true usually (read: always) are. And the idea that two assets can be negatively correlated but rally simultaneously is an example of something that’s too good to be true.
That state of affairs (wherein stocks and bonds diversified one another while both generally rallying over a multi-decade period) was a spectacularly fortuitous example of “having your cake and eating it too,” and the correlation assumption behind it became the bedrock principle of portfolio construction.
But (and this is the crucial point) it’s not a bedrock principle. Like a lot of other phenomena witnessed over the same time period, it was an anomaly. A historical aberration, facilitated in no small part by other anomalies which we mistook for “the new normal” — anomalies like subdued macro volatility.
The figure above (or some version of it) was popular Thursday, and I wanted to briefly highlight it here because the choice of window (i.e., the 30-year lookback) isn’t an accident.
Three decades is a long time, and if you were investing professionally in 1995, that means you’re at least 48 years old now. Obviously, the visual looks different depending on how you define the parameters (that chart uses the one-year rolling correlation, for example), but the implication is that you have to be over 50 years old to claim professional experience building multi-asset portfolios without the assistance of a reliably negative stock-bond return correlation.
I have no idea what the age breakdown looks like for multi-asset investors, but I assume there are quite a few people managing large sums of capital in 2023 who haven’t reached the half-century mark. For those managers, the flipped correlation shown in the figure is tantamount to removing the proverbial training wheels. And not everyone is loving the experience.
Have a look at the figure below from Goldman. It’ll be familiar to some readers, but it’s always worth another look.
What we came to know as “normal” is actually the opposite of normal. Historically, the equity-bond correlation is positive. Measured on a 10-year rolling basis, it was almost always positive until 2000.
Going forward, and assuming inflation stays high and geopolitics remains unruly, it’s more likely that stocks and bonds will move together than it is that we’ll return to a “have your cake and eat it too” environment.
That’s why 60:40 may not be ideal. It’s plainly not ideal now. Not with USD cash yielding 4%.
When the history of the last two years is written, one of the key lessons will be that risk-free assets (e.g., Treasurys and gilts) are only risk-free if you’re holding them to maturity and if what happens to their market value between now and then doesn’t have implications for the rest of your portfolio — or, indeed, for the viability of your whole damn business model.
Coming full circle, it’s time for portfolio managers to accept that the world has probably changed. Rather than pray for a return to the idiot-proof conditions that prevailed for 30 years, it’s better to learn (or relearn, whichever the case may be) how to actually (and actively) manage risk.
I’m 78, and a shameless multi-asset investor with a portfolio consisting of 65% fixed income, a nice cash cushion and the rest in a mix of stocks. For the first 20 years my holdings were at least 90% in bonds, not because of any sense of bond-stock diversification, but for two other reasons. From the time the great bond bull started charging in the 20th Century, bonds, especially USTs selling at less than par, returned much more that stocks, especially when bought with a generous soupcon of other peoples’ money. The other reason for my choice is equally simple, borrowers sign contracts to pay you for using your money, and to pay you back at a stated time. Stocks don’t (and can’t) promise bupkis. I like promises people keep. The idea that for part of my investing life bonds diversified one’s portfolio when it contained stocks was a bonus. For much of the new century, ZIRP has killed bonds so I have gone up as high as 35% stocks. I still prefer promises kept, however, especially when they are tax-exempt. But now rates are up again and bonds are free to roam about the cabin. My investment income has risen YoY for all but one year of the current century so I will not be eschewing promises kept anytime soon. I’m now able to get FI vehicles at 25% discounts so once again, all is right with the world.