Rumors of the death of the 60:40 portfolio are exaggerated

Is there still a diversification benefit to owning both stocks and bonds?

You wouldn’t know it based on recent market action. Or even for most of the past few years.

Can Treasuries Still Help Diversify Stocks?

Low Duration Stocks

The classic 60:40 portfolio – 60% stocks and 40% bonds – was built on the premise that the asset classes aren’t well correlated. If your stocks went down, your bonds might go up, and vice versa. Not all the time, for sure, but enough to smooth out the ride.

At least they didn’t move in lock step. They’re not quite doing that now, but close enough that many investors are questioning whether the classic 60:40 portfolio is dead.

They could be forgiven for asking. Lately stocks and bonds have been almost joined at the hip. When stocks sell off, bonds have followed suit.

I think that’s a bit of a rush to judgment though, and will explain why. There are at least two ways of looking at diversification. One, assumed above, is statistical. List a series of historical returns and find the correlation coefficient. Another is fundamental. Assess to what extent to assets share a common source of risk.

This latter is our ongoing rationale for diversification, even when recent correlations seem high. The reason is simple … statistical correlations change. If what was once a low correlation between stocks and bonds can become a high correlation, it can become low again. And how long do you have to observe correlations to infer that past is prologue?

There is no amount of time that provides such assurance.

Fundamentals can shed more light on the question.

In this case, let’s look at the sources of return for stocks and bonds. For the purposes of the diversification question, the one that differs is the issuer, and its ability and willingness to pay the expected stream of income. The one that’s the same is the discount rate being applied to that expected income to determine its current fair value.

For stocks that stream of income is dividends. They will vary according to corporate profits or earnings. Even non-dividend-paying stocks are implicitly valued on the basis of dividends that might be paid in the future. The alternative is that the company liquidates, not a prospect investors usually pay up for. It might also be acquired, but not many super cap stocks could be readily acquired, and investors don’t uniformly just take the cash and run anyway. Either way, it’s dividends, or at least the capacity to pay dividends, that represent the cash flows that justify a stock’s price. And they in turn depend on corporate earnings prospects.

For bonds, particularly high quality bonds like Treasuries, that stream of income comes in the form of interest or coupons. They are set by contract, and do not depend on corporate profitability. Treasury payments are backed by the taxpayer, and backing that up is the ability of the government to print the cash needed if necessary.

This comparison highlights the fundamental diversification between stocks and bonds. Stocks are issued by corporations and their cash flows are contingent on corporate profitability. Treasuries are issued by the government and their cash flows are set by contract.

So what is the common factor?

The time value of money.

The gist of it is that if stocks are being driven down by falling profit expectations, we can expect bonds to provide ample ballast. If they’re being driven down by a changes in the time value of money, we can expect bonds to decline as well.

The latter understates the case though … since bond prices and yields directly reflect the time value of money, you could even say that declining bond prices are the cause of declining stock prices. In which case of course we wouldn’t expect bonds to go a different way.

For most of the past few years, corporate profitability hasn’t been a problem. Inflation has, and that has resulted in declining bond prices, and rising interest rates and yields. Under such circumstances, we wouldn’t expect much diversification benefit from combining stocks and bonds. We should expect them to be highly correlated.

The thing that would change that would be if the strength of corporate profits should come into question. Then we would expect bonds to provide much stronger diversification benefit.

Without that, the main benefit from bonds is that they decline less than stocks, and that depends on limiting durations. Short term treasuries provide most of the diversification benefit in environments where changes in the time value of money, as opposed to corporate profitability prospects, are depressing stock prices.

But if bonds can have different durations, can’t stocks as well? Glad you asked. Stocks that have lower prices and higher dividend yields (value stocks) return more cash in the early going than those with low or nonexistent yields, (growth stocks) which are being valued on prospective earnings in the distant future. These higher yielding stocks therefore have a lower duration. And in fact during the last bear market in 2022, they solidly outperformed long duration stocks. We’ve even seen some of that in the recent bout with rising rates and falling bond prices.

So the diversification axis in such an environment isn’t between stocks and bonds, but between short and long duration securities, whether stock or bond.

An example of a lower duration stock portfolio can be found on the Financology Model Portfolio page in the last few portfolios. These portfolios are notably underweight in high flyers like the Mag 7. To the extent declining security prices are being driven by changes in the time value of money (as opposed to weakening corporate profitability), lower durations across stocks and bonds should help buffer returns.

And as always, should diversifying beyond securities into other assets like commodities. What’s the duration of gold? You could say it’s zero or you could say it’s infinite. There are no cash flows … duration isn’t a factor. In that sense, the 60:40 wasn’t quite complete to begin with.

Bottom line … whether bonds rise when stocks fall depends on why they’re falling. If it’s changes in the time value of money, they’ll go down together. If it’s concerns about corporate profits, bonds are likely to rise.