A recent paper analyzing the correlation between stock and bond returns going back to 1875 suggests the relationship of the past quarter century is shifting in an uncertain inflationary environment. The results might stimulate some investors to rethink their portfolio allocations.
Researchers at the State of Wisconsin Investment Board and fund manager Robeco take a new look at one of the fundamental drivers of long-term investment risk/return ratios — how much equity and bond prices move together – in “Empirical evidence on the stock-bond correlation,”. The paper adds value to this well-studied area by taking the analysis back nearly a century and a half, and studying the UK, Germany, France and Japan in addition to the US.
Let’s start with the classic “stocks for the long run” argument, which asserts that equity markets will drive the lion’s share of portfolio growth over periods of 10 years or more and will very likely outperform bonds and other asset classes. Investors who accept it take most of their long-term risk in stocks.
But 100% in stocks is too risky for many investors, especially those saving for shorter horizons such as a house down payment, college tuition for children or imminent retirement. The conventional advice for these people is to take some money out of stocks and put it in bonds to reduce risk. But which bonds?
The simplest approach is to use money market funds or Treasury Bills, which can be bought directly from the Treasury with no fees. Since they carry very little risk, their correlation with equities doesn’t matter. They reduce risk because you’re buying less stock.
But most investors choose riskier bonds, such as 10-year or 30-year Treasury securities or corporate or foreign-currency bonds. As long as the correlation of these bonds with stocks is less than one, they offer diversification benefits. Up to a point, the more risk you take with the bonds, the more diversification benefits you get.