Does diversification still matter?

The start of 2022 was tough on the 60/40 portfolio.

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Key takeaways

  • Historically, stocks and bonds have had relatively low correlation, but in the first half of 2022, stock and bond returns were both negative.
  • 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.
  • 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 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 the first half of 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 this is unusual but not unprecedented," he explains. "However, over time I remain confident that a well-diversified portfolio can still provide returns that could help investors meet their financial goals."

Inflation and interest rates driving volatility

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"Stubbornly high inflation and the expectation that the Federal Reserve would raise interest rates to slow down overheated growth has been 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 recent stock market volatility is related to inflation, according to Schuster, it also reflects 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 particular, Strategic Advisers feels that fleeing markets in favor of cash could lead investors to miss out on the market's potential upswing.

Yet, despite comparisons to earlier decades, some investors may question the near-term direction of bonds as the Federal Reserve is likely to continue to raise rates throughout 2022. The good news is that these potential hikes have largely been priced in by bond markets in recent months, says Schuster. "From this perspective, it's possible that for high-quality bonds, some of the worst may be behind us," he says.

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 remain elevated," 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.

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 in 2022 is that bond yields are significantly higher than they were a year ago," 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.

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."

An approach for today's market

Given the potential for continued higher inflation, interest rate increases, and volatility, investors with well-diversified portfolios may want to consider strategies to help diversify beyond the broad categories of stocks and bonds. Schuster suggests spreading out a portfolio's exposure to bonds. Since US Treasuries have tended to struggle during inflationary periods, Strategic Advisers, LLC has been diversifying among other types of bond assets such as Treasury Inflation-Protected Securities (TIPS), and floating rate or bank loans. He also says that this could be a good time to rebalance portfolio allocations. In volatile markets, your asset allocation may drift from your intended mix. Rebalancing brings you back in line with your target allocation and allows you to sell some of your higher-priced investments while adding more lower-cost ones.

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