Here's why equity/bond correlations should soon return to normal, and why the 60/40 portfolio is far from dead.

While volatility in the financial markets is nothing new, given that ‘all investing comes with risk’, the stormy weather of 2022 has been enough to unmoor even the most seasoned of investors. Even investing truisms like ‘time in the market, not timing the market’ that typically help investors stay the course are on shaky ground. One investing truism that has lost the support of many an industry commentator is ‘bonds provide ballast in a multi-asset portfolio’.

While the relationship between bonds and equities has traditionally been inverse – when one falls, the other tends to rise – for much of 2022, the impact of rising interest rates and inflation has created a painful anomaly where both are performing badly, at the same time.

Is it then time to dismiss bonds as effective equity market shock absorbers, and declare the 60/40 portfolio dead?

Before giving up on the bond portion of your portfolio, here are a few points for consideration.

It may come as a surprise to many investors, but this is not the first time where equities and bonds are positively correlated. Rather, the history books tell us that such fluctuations in this stock-bond relationship are not uncommon, especially when looking at the data over short time periods. In fact, the data shows that since 1995, investors have not experienced more than a cumulative 3-year period of losses in both equities and bonds. Overall, concurrent negative returns in both global shares and bonds have only occurred less than 13% of the time, or on average, a month of joint negative returns every seven months or so.

Importantly, the history books also indicate that these periods of positive correlation are generally short lived, and the diversification benefits that bonds bring to a portfolio persist over the longer term. In fact, Vanguard research suggests that for investors with a longer time horizon of 10 plus years, the transient correlations of equities and bonds have very little impact on expectations for and uncertainty in long-term multi-asset portfolio outcomes.

As numerous academic studies have shown, it’s the Strategic Asset Allocation decision that drives the vast majority of portfolio returns over the long term rather than market timing or security selection. So contrary to the naysayers, the data over the long-term suggests that diversification properties of a portfolio including allocations to equities and bonds are likely to remain intact.

Case in point, Vanguard projects the long-term average annual return of a 60/40 equities/bonds portfolio to be around 5.5% over the next three decades. But the inherent volatility of financial markets means returns will be uneven, comprising periods of returns that are higher or lower- potentially even negative, as we’ve experienced throughout this year.

Dismissing the value of a bonds in a balanced and diversified portfolio based on an event that has historically occurred 13% of the time is akin to giving up on a marathon despite the countless of hours training for it, because both your lungs and legs were simultaneously giving you a hard time during 13% of the race.

Stretches like the beginning of 2022 – and some bear markets that have lasted much longer – inevitably test investors’ patience and mettle. But just like running a successful marathon, successful investing over the long term demands perspective and discipline. And disciplined long distance runners and investors both know that those moments of extreme pain eventually subside and sticking to your race plan is usually the key to making it to the finish line.

The fundamental relationship between equities and bonds is not broken. This isn’t the first time that a diversified portfolio and markets in general have faced turbulent waters – and it certainly won’t be the last. Equity/bond correlations should be returning to normal shortly and the 60/40 portfolio and all its variations are far from dead.

Far from abandoning a well-diversified strategic asset allocation within a portfolio, investors should maintain a focus on the plan and objectives they have set.

If you are a long-term investor thinking about what opportunities the market is serving up today, remember that at the end of 2021 markets looked expensive and after the rollercoaster of 2022, pricing across the board is more attractive. Your impulse should be to add exposures back to the portfolio, including bonds, trusting that bonds will be back to their balanced portfolio stabilising ways soon.

And based on history, a well-diversified portfolio is ready to prove the naysayers wrong again and talk of their demise is ultimately a distraction from the business of investing successfully over the long term.

Vanguard Australia