Correlation and Diversification
Some investors have expressed concern about a recent increase in the correlation between global stocks and bonds, seeing this as a sign that the diversification benefit from adding bonds to a portfolio is starting to wane. However, the data shows these concerns may be misplaced.
Over the 31 years from January 1993 to February 2024, the average correlation between global stocks and bonds has been close to zero. However, the 36-month correlation as of the latter date has risen to about 0.6. (For context, a correlation coefficient of 1 indicates a strong positive relationship. A correlation coefficient of -1 indicates a strong negative relationship.)
But using correlations to measure diversification benefit can be problematic. This is in part due to their instability, a fact obscured by long-term averages. Over our 31-year period, for instance, correlations between global stocks and bonds oscillated from between as low as -0.57 to as high as 0.68.
The exhibit below shows that while correlations vary over time, the benefits of adding bonds to a stock allocation to reduce overall portfolio volatility are just as present today as in the past.
The teal line represents the extent to which adding fixed income to equities reduces volatility. Specifically, it shows the ratio of trailing three-year standard deviation values for an asset allocation of 60% global stocks/40% global bonds relative to a 100% global stock allocation. By contrast, the yellow line represents the changing correlation between global stocks and bonds in this period.
You can see that teal line is stable compared with the correlation line. In fact, the reduction in volatility has stayed relatively consistent around 0.6 over the past 31-plus years. In contrast, correlations have waxed and waned widely between positive and negative.
In summary, while there has been a recent rise in correlation between global stocks and bonds, this measure tends to be volatile and should not be used as an indicator of the effectiveness of the role bonds play in reducing overall portfolio volatility.
One Doesn’t Look Like the Other
Relation between Global Stock and Bond Returns, Rolling 36-Month Values, January 1993–February 2024.
Past performance is not a guarantee of future results.
This article originally appeared in Short N Sweet, a newsletter for Dimensional clients.
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