The Diversification Challenge

The Diversification Challenge

Investors have relied on the tried-and-true 60/40 portfolio mix for years. This implies a portfolio that is invested 60% in stocks and 40% in bonds. For years, this mix has provided investors with both capital appreciation and a steady stream of income. More importantly, it has provided protection from short-term market volatility. This is due primarily to the inherent diversification benefits of owning a mix of uncorrelated assets. When assets, or classes of assets such as stocks and bonds, are correlated, it means that when the price of one goes up, they all go up. Conversely, when the price of one goes down, they all go down. Stocks and bonds have typically moved in opposite directions. Recently, however, that relationship has been broken, with stocks and bonds moving in tandem and, subsequently, reducing the downside protection formerly provided by diversification.

What Changed?

The primary driver of the negative correlation between stocks and bonds has been the inverse relationship between prevailing interest rates and corporate earnings. However, there are rare occasions when market dynamics push stock and bond results in the same direction. Take, for instance, 2022 when the Fed aggressively raised rates 11 times. This type of aggressive action by the Fed is very uncommon, and it caused bond markets to experience a drawdown. The outlook for corporate earnings also dropped precipitously, which was reflected in a stock market that lost over 18% during the year. Interest rate sensitive sectors like technology were hit especially hard. Recently, however, we have witnessed a prolonged period where profits continue to increase, despite the elevated level of interest rates. And since interest rates are driven largely by the Fed, and the Fed is driven largely by inflation, then it should come as no surprise that rates are still elevated. If inflation continues to sit above the Fed’s 2% target, the likelihood of a cut anytime soon is rather low. With short-term interest rates hovering above 5% it looks as though stocks and bonds might continue marching together in the same direction, at least in the short term.

What Can Investors Do?

Stay the course. One of the worst behavioral mistakes an investor can make is implementing tactical changes to their strategic allocation in response to short-term market conditions. Another thing investors should consider is their specific mix of bonds. Not all bonds are created equal and that provides investors with an opportunity to achieve at least some degree of diversification. One such method is owning individual bonds, carefully curated by professional investment managers, which aim to achieve explicit outcomes. This is in sharp contrast to owning a bond fund or a bond ETF, which aim to be all things to all investors. Owning individual bonds allows the investor to maintain specific credit and duration exposure which should provide at least some degree of diversification, and ultimately lead to improved portfolio performance.

Even though stocks and bonds are not currently exhibiting their traditional push-pull relationship, it doesn’t mean that investors can’t still take advantage of a strategic mix of both. It does, however, require the investor to be more deliberate with respect to the composition of his or her bond portfolio. Ownership of professionally selected individual bonds is one of the best ways to achieve this objective.