Asset allocation is the art and science of balancing risk and reward, tailored to the individual investor's goals, risk tolerance, and investment horizon.

Central to this balancing act is the concept of stock-bond correlation—a measure that signifies how stocks and bonds move in relation to each other.

This correlation, far from being a static number, fluctuates over time, influenced by economic cycles, monetary policy, and global events.

Most advisors assume that stocks and bonds move in opposite directions, providing a natural hedge against volatility. However, this relationship is not a constant; there have been periods when both asset classes have moved in tandem, either upwards or downwards, challenging traditional diversification strategies.

Historically over the 1928 to 2023 period, US stocks and bonds correlate 0.02, statistically indistinguishable from zero. The long-term correlation does, however, mask great variability over time.

The dynamic nature of the stock-bond correlation underscores the need for investors, particularly Baby Boomers and Gen Xers looking to optimize their asset allocation for retirement, to remain vigilant and responsive to market signals.

Understanding the Stock-Bond Correlation

Correlation measures the degree to which two assets move in relation to each other.

• This relationship is quantified on a scale from -1 to 1.

• A correlation of 1 indicates that the assets move perfectly in tandem.

• A value of -1 signifies they move in opposite directions.

• A correlation of 0 represents no relationship at all.

For investors, understanding this concept is pivotal, particularly when it comes to stocks and bonds, the two primary components of most retirement portfolios.

Historical Perspective and Its Influence

Traditionally, stocks are viewed as high-reward but higher-risk investments, while bonds are considered safer but with lower potential returns. The magic of stock-bond correlation lies in its power to balance this risk-reward equation.

Historically, during times of stock market volatility or downturns, bonds have often increased in value or remained stable, providing a cushion for investors. Conversely, in bullish stock markets, bonds might underperform but still add a layer of security.

For instance, during the dot-com bubble burst in the early 2000s and the financial crisis of 2008, investors who had diversified portfolios with both stocks and bonds generally experienced less volatility and recovered their losses quicker than those heavily skewed towards stocks.

The Changing Dynamics

However, this relationship between stocks and bonds isn't fixed.

Various factors, including inflation rates, interest rate policies by central banks, and overall economic health, influence this correlation.

• For example, in periods of low interest rates and economic growth, stocks and bonds may exhibit a positive correlation, moving together as investors seek both safety and growth.

• Conversely, in times of economic uncertainty, the correlation may become more negative, as investors flock to bonds as a safe haven, driving their prices up and yields down, while stocks may suffer.

This evolving nature of stock-bond correlation highlights the necessity for investors to not only diversify their portfolios but also to stay informed and flexible, ready to adjust their asset allocation in response to shifting market conditions.

The Current Picture

Stocks and bonds are the two most important asset classes. Rightly so, the stock/bond allocation mix is the most important determinant of the risk/return profile of most people’s portfolios.

Deciding how much to allocate to stocks and bonds is part of formulating an overall asset allocation mix that depends on the attractiveness of all key asset classes, their risks, and co-movement relative to each other subject to the unique risk tolerance and circumstances of the investor.

At the end of the day, whether you call your inputs forecasts, historical tendencies, or just a view, one of the most important assumptions you need to make relates to the expected behavior of stocks versus bonds. The correlation coefficient encapsulates the issue.

The implications of the stock/bond correlation are significant:

• A rising correlation diminishes the diversification potential of bonds and may result in higher overall portfolio risk.

• A lower correlation enhances the diversification potential of bonds and may result in lower overall portfolio risk levels.

• A range-bound, stable correlation between bonds and stocks will shift the importance of the individual asset classes' expected risk/return profile.

A Look at Rolling Correlations

An analysis of annual stock and bond returns from 1928 to 2023 yields a correlation of 0.02. Over that whole period, there is no co-movement between stocks and bonds.

Looking over shorter time frames we see a lot variability. At times the relationship is positive and at other times it is negative. It’s dynamic depending on a host of factors from investor risk preferences to monetary policy.

The chart below highlights the time-varying nature of stock/bond correlations. We use the daily returns of the S&P 500 and the Bloomberg US Aggregate Index. We estimate correlations using a rolling window of 66 and 252 days. The shorter, 66-day window will move faster than the longer window.

The current 66-day correlation is 0.23 while the 1-year window correlates 0.22. These estimates will frequently differ and it’s by coincidence that they are, at the moment, essentially equal.

The real story is the volatility of these correlation numbers. Over the last two years, the 66-day correlation has risen to close to 0.6 and dropped to -0.4. The longer window of 1-year estimates has gone from essentially zero to a high close to 0.4 and then back to the 0.2 region.

What assumption you use will prove important. In our long-term work, we are currently assuming the following correlations relative to US Large Cap Equities.

These forward-looking assumptions represent a mix of historical tendencies and current shorter-term estimates adjusted by our proprietary Risk Aversion Index (RAI).

At the moment we are assuming:

• A 0.2 correlation between US Large Cap Equities and broad US bonds.

• The greatest diversification potential at the moment comes from the fixed-income contribution.

• Equity-related asset classes (US large and small cap, Intl Developed, and Emerging Mkt Equities) are not great diversifiers at the moment.

• Commodities move to their tune with little correlation to the other asset classes.

• Real Estate is a mixture of interest sensitivity and equity market exposure. It seems to be more of a stand-alone asset at the moment.

Adapting to Market Evolution

The financial markets are a reflection of the world we live in, constantly influenced by geopolitical events, economic cycles, and technological advancements.

These factors contribute to the fluid nature of risk and the correlation between different asset classes, making static investment strategies potentially less effective over time.

For investors, particularly those in retirement or nearing it, understanding that risk levels and asset correlations are not fixed is crucial to safeguarding their wealth.

Several instances in history underscore the importance of recognizing and adapting to changes in risk and correlation.

The 2008 financial crisis is a prime example, where the correlation between asset classes increased dramatically, leading to widespread portfolio losses.

Similarly, the COVID-19 pandemic in 2020 caused unprecedented market volatility, with initial declines in both stocks and bonds, challenging traditional diversification models.

Strategic Asset Allocation Adjustments

Given these realities, the key to maintaining a resilient portfolio lies in flexibility and ongoing adjustments.

For instance, in periods of expected high volatility or when traditional correlations start to break down, increasing allocations to uncorrelated strategies such as commodity trading advisors (CTAs), or hedge funds specializing in esoteric areas of the capital markets might provide additional diversification benefits.

Similarly, leveraging forward-looking models that incorporate current market conditions and expected changes in correlations can help in fine-tuning asset allocation to better manage portfolio risk.

Actionable Adjustment Strategies

Reoptimizing: Regular portfolio reviews and reoptimizing allocations based on the risk & correlation environment ensures that your asset allocation remains aligned with your risk tolerance and investment goals. This may involve selling top-performing assets during periods of low diversification potential. It may also involve buying more of asset classes deemed to have beneficial diversification potential.

Tactical Asset Allocation: This strategy allows for short-term adjustments in your asset allocation based on current market conditions or forecasts. For example, reducing exposure to stocks in favor of bonds during periods of expected stock market volatility can help protect your portfolio.

Incorporating Alternative Investments: Adding non-correlated assets, such as commodities, or private equity, can further diversify your portfolio and reduce the impact of stock-bond correlation changes.

While navigating the complexities of stock-bond correlations and adjusting your asset allocation can seem daunting, it also presents an opportunity to enhance your portfolio's performance and resilience.

The journey of retirement investing is not one of set-it-and-forget-it; it's a continuous process of adjustment and adaptation to the ever-changing market conditions. By staying informed about the shifts in stock-bond correlation and employing strategic asset allocation adjustments, investors can better manage risk and seek to maximize their portfolio's potential.

The path to a resilient and thriving portfolio in retirement requires vigilance, flexibility, and a proactive stance toward investment management.

Embracing the fluid nature of financial markets and the tools at our disposal for navigating these changes, investors can approach their retirement years with confidence.

Remember, the goal is not just to survive the financial ups and downs but to thrive, making the most of your investments to secure a fulfilling and prosperous retirement.

Asset Allocation Performance Review

High-Level Observations:

• Conservative portfolios with a heavier allocation to bonds lost ground over the last five days. Both US and International fixed income performed poorly as rates spiked up.

• The performance of international investments was further hit last week with currency losses as the US dollar kept appreciating.

• Over the last three years, the GF Low-Risk strategy is only up 1.8% on an annualized basis (before fees and transaction costs). Going back 5 years the annualized performance improves to 4.7%.

• Equity-heavy allocations have outperformed more conservative allocations thanks largely to the performance of US large-cap equities.

• The GF Higher-Risk strategy is up 3.9% on an annualized pre-cost basis over the last three years. Over the last 5 years, the strategy is up a respectable 7.6%.

• The environment remains risk-on but has become less bullish as investors adjust their thinking of the likely path of interest rates. Our Risk Aversion Index (RAI) remains in the Exhuberant zone.

• We remain overweight equities and underweight bonds in our active models. Our contrarian bet is real estate and we are currently holding higher than average allocations to cash.

Weekly Performance Attribution

Source: iShares, as of 4/2/2024

A Bit of Humor Never Hurts

Disclaimer: This newsletter is not trading or investment advice but for general informational purposes only. This newsletter represents my personal opinions which I am sharing publicly as my blog. Futures, stocks, and bonds trading of any kind involve a lot of risk. No guarantee of any profit whatsoever is made. You may lose everything you have. We guarantee no profit whatsoever, You assume the entire cost and risk of any trading or investing activities you choose to undertake. You are solely responsible for making your own investment decisions. Owners/authors of this newsletter, its representatives, its principals, its moderators, and its members, are NOT registered as securities broker-dealers or investment advisors either with the U.S. Securities and Exchange Commission, CFTC, or with any other securities/regulatory authority. Consult with a registered investment advisor, broker-dealer, and/or financial advisor. By reading and using this newsletter or any of my publications, you are agreeing to these terms. Any screenshots used here are the courtesy of Global Focus Capital and Retirement With Possibilities. The data, quotes, and information used in this blog are from publicly available sources and could be outdated or outright wrong - I do not guarantee the accuracy of this information.