The Diversification Challenge

The Diversification Challenge Investors have relied on the tried-and-true 60/40 portfolio mix for years. This implies a portfolio that is invested 60% in stocks and 40% in bonds. For years, this mix has provided investors with both capital appreciation and a steady stream of income. More importantly, it has provided protection from short-term market volatility. This is due primarily to the inherent diversification benefits of owning a mix of uncorrelated assets. When assets, or classes of assets such as stocks and bonds, are correlated, it means that when the price of one goes up, they all go up. Conversely, when the price of one goes down, they all go down. Stocks and bonds have typically moved in opposite directions. Recently, however, that relationship has been broken, with stocks and bonds moving in tandem and, subsequently, reducing the downside protection formerly provided by diversification. What Changed? The primary driver of the negative correlation between stocks and bonds has been the inverse relationship between prevailing interest rates and corporate earnings. However, there are rare occasions when market dynamics push stock and bond results in the same direction.