Stock market performance and bonds yield have a complicated (cor)relationship: it is important to understand the nature of the correlation between stocks and bonds, two asset classes which, alone, are the pillars of investment for the majority of savers.
The correlation between investment trends is imperfect and is a fundamental prerequisite for portfolio theory. Because, in simple terms, if there were no imperfect correlation it would not make sense to build diversified portfolios – that is, they contain different investments – in order to reduce their overall risk.
First, what is the statistical correlation (briefly): it is a measure of the intensity with which two or more variables (in this case stocks and bonds) “move together” and is between -1 and 1. The more the variables move perfectly together in the same direction and the more the correlation will have a value close to 1, the more they move together but in the opposite direction (one increases and the other decreases) and the more the correlation will have a value close to -1 (inverse correlation). Values around 0 indicate little or no correlation.
So let’s take the performance of the equity market represented by a stock market index, and the performance of the bond market represented by bonds yield to maturity (there are long historical series, which offer an interesting perspective in recent decades).
Is there a correlation between returns on stocks and bonds?
As said, the correlation between bonds and equities can be of these two types:
- if the correlation is positive, it means that when the stock market index rises the yield of the bonds also rises (and therefore their price falls, due to the inverse relationship between price and yield of a bond); and vice versa, if the stock market falls, the yield on the bonds will drop
- if the correlation is negative (inverse correlation), when the stock market goes up the yield of the bonds goes in the opposite direction (and therefore the price goes up); vice versa if the stock market falls
Unfortunately, many savers imagine an ideal world in which the values of stock market indices and yields of the bonds are positively correlated, that is, if the stocks rise also the yield on maturity of the bonds increases, and vice versa:
- when the stock exchanges go badly, investors sell stocks and rush to buy bonds, the price of which therefore rises, while the yield to maturity falls
- on the contrary, when the stock exchanges go up, investors sell the bonds, causing the price to drop and the yield to mature
If so, it would be a paradise for investment diversification. But the correlation between equities performance and bonds yield not at all so perfect, as history shows.
This graph shows the historical correlation between world stock exchanges and bond global returns from 1964 to today:
It is not easy to give a unique interpretation for such a long and complex historical series, but the main elements seem to be the following.
The correlation bonds yield – stocks performance varies greatly over time
The first thing you notice is that the relationship between the yield on bonds and the stock market performance is sometimes positive (as in the “paradise of diversification”), other times it is negative. In the latter case, therefore, exchanges and bonds go down or rise in harmony, so that portfolio diversification is less effective.
On average, the correlation between stocks and bonds is zero
The average from 1964 to today is -0.06: practically zero. This is also true in most of the subperiods of a certain length (about ten years), which suggests that it is reliable. This is comforting because it means that diversifying your investment portfolio works.
Diversification across asset classes works (in the medium-long term)
In fact, having investments with an average correlation of zero means having a well structured and diversified portfolio. Yes, because a correlation of less than 1 is enough to enjoy the benefits of diversifying investments.
But be careful: the correlation fluctuates, therefore diversification should not be expected to always work in every single day or month of the investment, it needs time and patience.
In conclusion, although the correlation between bond yields and the stock exchange varies greatly over time, in the medium to long term diversifying investments between equities and bonds reduces risks to a minimum.
It is therefore not appropriate to lose heart if for some time the whole portfolio goes badly, because history teaches that portfolio diversification works on medium-long investment horizons.