Commentary
Correlation anxiety and the reality of diversification
In recent months, the correlation between stocks and bonds has been a controversial topic in the financial press
Correlation anxiety and the reality of diversification
In recent months, the correlation between stocks and bonds has been a controversial topic in the financial press. A rise in the degree to which they move in tandem has pundits questioning the future of traditional 60/40 stock/bond strategies1 and, in some extreme cases, the asset classes’ diversification profile2 altogether. We consider these concerns overwrought—and the math is on our side.
Diversification math
There is a common misconception that traditional stock/bond strategies rely on a negative correlation (in which one tends to rise in value when the other falls) for their diversification benefit. In reality, the benefits of diversification are not so fragile. While a lower correlation between stocks and bonds reduces a stock/bond portfolio’s expected volatility, all else equal, that relationship holds across all levels of correlation. As long as the asset classes do not exhibit perfect positive correlation (as represented by a correlation coefficient of +1), owning exposure to both will inherently yield diversification benefits. Positive correlation does not negate the benefits of diversification; meaningful benefits exist even when correlation is consistently above zero.
Fundamental portfolio mathematics helps to explain this dynamic. In a multiasset portfolio, expected returns are a linear function of expected asset class returns; the portfolio’s expected return is a simple weighted average of that of its components. In contrast, portfolio risk (e.g., expected standard deviation) does not follow that linear relationship. As long as the correlation between asset classes is less than perfect, the portfolio’s expected risk will be lower than that of the weighted average of its components. This math, and the associated benefits for portfolio construction, holds true whether correlations are positive or negative.
1Eric Wallerstein, “The Trusted 60-40 Investing Strategy Just Had Its Worst Year In Generations,” The Wall Street Journal, October 19, 2023.
2Ye Xie, “Bonds Are Useless Hedge for Stock Losses as Correlation Jumps,” Bloomberg, August 2, 2023.
Glossary
Alternative investments are financial assets outside of traditional asset classes (stocks, bonds, and cash).
Standard deviation is a statistical measure of the historical volatility of an investment. It measures the average periodic divergence from the investment’s average return. A volatile stock has a high standard deviation, while the standard deviation of a stable blue-chip stock generally is lower.
Treasurys are U. S. government debt obligations backed by the full faith and credit of the federal government. They are often used as a proxy for a risk-free asset for benchmarking and asset-valuation purposes.
Important information
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results. Positioning and holdings are subject to change. All information as of the date indicated. There are risks involved with investing, including possible loss of principal. This information should not be relied upon by the reader as research or investment advice, (unless you have otherwise separately entered into a written agreement with SEI for the provision of investment advice) nor should it be construed as a recommendation to purchase or sell a security. The reader should consult with their financial professional for more information.