How 60/40 investing provides 20/20 clarity

August 14, 2021

Topics: Inflation | Asset Allocation | Rebalancing | Diversification

Media type: Article, Podcast

How 60/40 investing provides 20/20 clarity

4.9 minute read • 

August 14, 2021

Inflation is rising in many parts of the world, which means interest rates are also expected to rise. Financial asset pricing models suggest that inflation can have similar effects on stocks and bonds due to a common relationship with short-term interest rates. Here’s why some investors are starting to wonder:

Will stock and bond yields begin to move in tandem? If so, what does this mean for balanced portfolio diversification?

To answer these questions, my colleagues and I have identified the factors that have historically influenced stock and bond movements over time and published our findings in Stock/Bond Correlation:

Increase in inflation, but no regime change. The most important of these drivers is inflation, and we have found that it takes a much higher inflation rate than expected for stocks and bonds to move together as this reduces the ability to diversify bonds in a balanced portfolio. . 1

Why long-term investors keep balanced portfolios

Understand why it’s important for so many investors to have a balanced portfolio of stocks and bonds. Equities are the engine of growth in a portfolio and the source of higher expected returns in most market environments. However, investors have little incentive to hold bonds if they consistently outperform bonds or otherwise guarantee results. Although stock prices have historically increased over time, their trajectories have not been linear. Along the way, they experienced many bumps and several sharp contractions.

This is where mortgages come in. Bonds often act as portfolio ballast, with prices rising or falling less during periods of declining stock prices. This distinct return model helps to reduce the loss of portfolio value compared to an all-equity portfolio. This helps investors stick to a well-thought-out plan in a tough yield environment.

Context Dependency:

time is important

We use the term correlation to explain how stock and bond returns relate to each other. When returns generally move in the same direction, they are positively correlated; when they move in different directions, they are negatively correlated. A combination of negatively correlated assets will improve diversification by smoothing fluctuations in the value of portfolio assets over time. More recently, however, stock and bond returns have moved more often in the same direction, sometimes even positively. But these positive correlations occurred over a relatively short period of time. And, it turns out, timing is everything.

Short-term trends may vary; long-term positive or negative correlations can persist for decades

The chart shows short-term fluctuations in the stock/bond correlation, including spikes in positive correlation, but also stable long-term negative correlation since 2000. Remarks:

The long-term equity/bond correlation was largely positive for most of the 1990s, but has been mostly negative since about 2000. It’s not uncommon for correlations to turn positive in the short term, but that doesn’t change the long-term negative correlation relationship. .

The source:

Vanguard, based on Refinitiv data from January 1, 1990 through July 26, 2021. Data does not appear on the chart until early 1992 to reflect the end of the first 24-month moving correlation.

Past performance is not indicative of future returns. As with any investment return, looking only at the short term will tell you a lot. Since 2000, the equity/bond correlation has risen several times into positive territory. However, the long-term correlation remains negative and we expect this trend to continue.

How much inflation is needed?

Our research identifies the main factors influencing stock and bond correlations from 1950 to the present day. Of these, long-term inflation is the most important.

Since inflation moves stock and bond returns in the same direction, the question becomes:

What level of inflation is needed to change the return correlation from negative to positive? Reply:

Very.

According to our data, the rolling 10-year average inflation rate is 3.5%. It’s not the annual inflation rate, it’s the 10-year average. For context, we need to keep annual core inflation at 5.7% to reach the 3-year average soon, say within the next five years. By contrast, we expect core inflation to hover around 2.6% in 2022, pushing the historical 10-year average to just 1.8%.

You can read more about our outlook for US inflation in our recent article The Inflation Machine:

What is it and where is it going. To ensure price stability, the Fed is targeting an average annual inflation rate of 2%, well below the threshold that we believe will lead to a positive correlation of any significant duration. It is also well below pre-2000 inflation, which averaged 5.3% from 1950 to 1999, and corresponds to a positive long-term equity/bond correlation. A positive correlation requires high inflation

The chart projects rolling 24-month stock/bond correlations for different scenarios tracking the 10-year average inflation from 2021 to 2031. According to our research, a 2% tracking 10-year average inflation rate would lead to a 24-month rolling correlation of minus 0.27 after; a 10-year average inflation rate of 2.5% would result in a negative correlation of 0.14; An inflation rate would result in a correlation of 0.25; a ten-year average inflation rate of 3.5% would result in a correlation of 0.36.

Please note:

The chart shows Vanguard’s forecast for stock-bond correlations under four 10-year inflation scenarios from April 2021 to December 2025.

The source:

avant-garde.

Asset allocation can affect portfolio results more than correlations

What does this mean for a traditional portfolio of 60% stocks and 40% bonds? For investors willing to adjust their portfolios to prepare for a reversal in the equity/bond correlation, we can say, “Not so soon. drawdowns, but have little effect on the portfolio’s range of long-term results. More importantly, we find that shifting the portfolio’s asset allocation from 60% to equities leads to a larger shift in the portfolio’s risk profile than the remaining 60/40 of the portfolio during the regime shift period. concerning.

This relates to something you may have heard us say before:

Portfolio results are largely determined by the investor’s strategic asset allocation. That’s good news, because with proper planning, investors with balanced portfolios should be in a good position to stay on track to achieve their goals, rather than swerving to avoid bumps in the road.