The Nobel prize-winning economist Harry Markowitz described diversification as the "only free lunch in finance." But recent market volatility may have some investors looking for a new menu. Historically, stocks and bonds have had relatively low correlation so that a portfolio that was balanced between them—for example, one with an allocation of 60% in stocks and 40% in bonds—would usually have some assets that were growing as others declined, therefore dampening the effect of market volatility.
But in 2022, stock and bond returns were both negative, a pattern rarely seen since the late 1970s and early 1980s, explains Lars Schuster, institutional portfolio manager with Strategic Advisers, LLC, the investment manager for many of our clients who have a managed account. "A period like 2022 was unusual but not unprecedented," he explains. "However, over time I remain confident that a well-diversified portfolio can still provide returns that can help investors meet their financial goals."
Inflation and interest rates driving volatility
"High inflation and aggressive rate hikes from the Federal Reserve to slow down overheated growth was likely the key driver of both stock and bond volatility in 2022, " says Schuster.
Inflation is generally known as the enemy of bonds, since it reduces the value of their future interest payments, causing prices to fall. In addition, as interest rates rise, so do bond yields. Since investors are more likely to purchase new bonds with higher yields, prices for existing bonds with lower yields generally fall. Whether or not stock prices are affected by inflation tends to be industry and even company specific. For example, for some companies, the higher cost of goods can translate into lower sales as consumers pull back, while others, such as energy companies, can benefit from higher prices.
While 2022 market volatility was related to inflation, according to Schuster, it also reflected concerns about the potential for a recession given that higher interest rates are designed to tame inflation by slowing growth.
Keeping things in historical perspective
Throughout history, stock and bond markets have gone through challenging, near-term readjustments when inflation and interest rates have surged. However, investment returns have traditionally stabilized and shifted upward over time. Since 1926, well-diversified portfolios that have included a mix of stocks, bonds, and short-term investments have posted positive returns in the 3, 5, and 10 years after a period of high inflation.
Because of this, Strategic Advisers believes patient investors who stick with their financial plans through near-term challenges have usually had better success in reaching their financial goals. In fact, investors who fled markets a year ago in favor of cash likely missed out on the market's rebound as inflation eased and the pace of rate hikes slowed.
Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. It is not possible to invest directly in an index. Balanced Portfolio: 42% U.S. Stocks—Dow Jones U.S. Total Stock Market Index; 18% International Stocks—MSCI ACWI ex USA Index, 35% Investment-Grade (IG) Bonds—Bloomberg U.S. Aggregate Bond Index, 5% Cash — Bloomberg 1–3 Month T-Bills. Inflation: 12-Month Rolling CPI—Urban Index. Returns are calculated starting in inflation period but include all subsequent periods for their holding horizon. Source: Bureau of Labor Statistics, Haver Analytics and Fidelity Investments (AART). Asset class total returns are represented by indexes from the following sources: Fidelity Investments, Bloomberg, ICE BofA. Fidelity Investments source: a proprietary analysis of historical asset class performance, which is not indicative of future performance. As of 4/30/2022.
While there is still uncertainty about how much further, if at all, the Fed may lift interest rates it appears that the most aggressive portion of the rate hiking cycle is over, says Schuster. “Last year was a painful readjustment given high inflation but, it's possible that for high-quality bonds, some of the worst may be behind us," he says.
Moreover, the higher rates we've seen also raises Strategic Advisers' confidence that bonds can still play an important role as shock absorbers for well-diversified portfolios. "That's because the higher the yield, the more cushion a bond can provide a well-diversified portfolio should stock market volatility return," says Schuster. Looking back at the long-term, rising interest rate environment between the late 1940s and 1980, one can see how bonds acted as diversifiers in years when stocks were down.
Past performance is no guarantee of future results. Bond returns are represented by the performance of the Bloomberg Aggregate Bond Index from January 1976 through December 2018 and by a composite of the IA SBBI Intermediate-Term Government Bond Index (67%) and the IA SBBI Long-Term Corporate Bond Index (33%) from January 1926 through December 1975. Stock returns are represented by the performance of the S&P 500 Index. Source: Morningstar EMCOR, Fidelity Investments (AART) as of 12/31/21.
Thinking beyond bond returns
The lengthy bull market for fixed income may have lulled some investors into thinking that the goal of holding bonds is to increase returns, explains Schuster. "For the past 40 years as interest rates fell, investors have seen an exceptionally strong bond market," he notes. "Going forward, returns may be more muted, so investors may need to reset their expectations."
Investors in well-diversified portfolios may take comfort in the fact that the pain of higher interest rates this year may help boost future total returns. "The upside of what's happened over the last year or so is that bond yields are significantly higher than they were in 2021," notes Schuster. "For a bond investor, yield can be a key element of future returns." Indeed, looking back at bond returns over the last few decades, it becomes clear that much of the total return delivered to bond investors has come from yield rather than price changes.
Price return is generated by the market price of the bond. Income return consists of coupons and interest received on the reinvestment of those coupons. Total return includes interest, capital gains, dividends, and distributions realized over a period. Past performance is no guarantee of future results. Source: Bloomberg Finance, L.P. from 8/31/1976 to 8/31/2023.
And over the long term, holding a diversified portfolio has historically been shown to reduce risk. "While a portfolio made up of 100% stocks might provide you with very strong returns, the question is whether you would be able to stay invested during periods of 25% drops or even more," explains Schuster. "Because the greatest detriment to an investor isn't staying in the market when it's a roller coaster—it's jumping off the ride altogether."