If higher inflation is here stay the conventional rule of 60%/40% portfolio allocation will not render a haven for investors.
The conventional wisdom approach to portfolio diversification prescribes that the wealth allocation mix should follow the 60/40 rule. According to this rule, 60% of the portfolio is allocated to stocks, and 40% to bonds.
Stocks are deemed to earn higher returns than bonds but also are more volatile, and therefore riskier, whereas bonds earn lower returns and are less volatile than stocks. This composition is based on the reasoning that stocks and bonds typically have a negative correlation, which means when one goes up, the other goes down, and therefore such a portfolio mix will provide a good balance between a portfolio’s risks and returns.
There is some evidence that particularly surfaced over 2020 – 2021 that suggests that the rationale of the negatively correlated stocks and bonds does not hold in the high inflation environment. With the rise of inflation returns on bonds may and do become positively correlated with returns on stocks.
Rising inflation prompts the Fed to raise interest rates, which hampers growth and reduces corporate profits. Higher inflation expectations boost rising bond yields, and the bonds market price goes down. Rising inflation and higher interest rates are also bad for stocks, as they lead to overvalued stocks and higher PE ratio. For comparison, in 1982, the S&P 500 price-to-earnings ratio was 8, and nowadays it has exceeded 30.
Rising inflation and short-term interest rates can trigger long-term bond yields to climb higher along with them, bringing down the overall return on long bonds, as was the case in 2021 when the overall return on Treasury Bonds reached -5 %. High inflation also affects corporate cash flows negatively, as it means higher discount rates on future corporate cash flows, decreasing the present value of equity. Thus, owing to the rise of inflation, returns on bonds become positively correlated with returns.
We can also trace a similar scenario of positively correlated stocks and bonds in the year 1970, when the stagnation period followed by rapid inflation made bond yields surge leading to significant losses on bonds’ returns.
If the inflation remains higher than it was over the past three decades, a 60/40 portfolio would not facilitate a good balance delivering stable returns. Investors may have to face the task of finding other solutions on how to hedge the 40% of what is allocated to bonds.
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