What Investors Should Know About The Correlation Between Bonds And Stocks

Tracy Alloway (0:10)

Hello, and welcome to another edition of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (0:15)

And I'm Joe Weisenthal.

Tracy Alloway (0:17)

So Joe, I think you're gonna enjoy today's episode because we are going to talk about one of the most intractable, most difficult problems in all of finance and investing. It starts with a C. Do you know where I'm going?

Joe Weisenthal (0:33)

Yeah, if you hadn't told me it was gonna start with a C, then my mind was not, I didn't totally know what you were about to say, but I think I'm pretty sure with that letter hint.

Tracy Alloway (0:46)

Okay, so I just gave it away, which wasn't my intention, but today we are going to talk about correlations.

And correlations historically have been quite difficult for banks and investors to model. And there's one correlation in particular, it's sort of the granddaddy of them all, and it tends to underpin a lot of investing. And over the past few years, we've seen more and more people start to question whether or not it actually exists in the way that we think it does, and whether or not that correlation, that particular relationship is going to hold true in the future. And now I definitely know that you know what I'm talking about.

Joe Weisenthal (1:27)

Right, of course, a lot of people have portfolios consisting of some slug of equities, which are perceived as being risky assets, and some chunk of safety assets like bonds. And over the long, well, over the short term, you sort of expect them to move in opposite directions and so on.

Days when people are scared, your safety assets rise and your risky assets fall and vice versa on bullish days.

But none of this is guaranteed basically, just because for some period of time, two different assets may have behaved and had some relationship does not necessarily mean that that relationship will persist forever. And hence, a good portfolio is not a easy thing to achieve.

Tracy Alloway (2:13)

Right, so you think about a standard portfolio and the thing that usually comes up is 60-40, right? That particular breakdown between bonds and equities, it's supposed to be a diversification play.

The two asset classes are supposed to move in different directions, but we have actually seen a couple times this year where they didn't do that, where bonds and stocks fell in tandem. And of course, a bunch of people started asking whether or not this was the start of a historic break in that relationship. So again, this is probably one of the most important correlations in all of modern investing.

Joe Weisenthal (2:49)

Early February, we saw that, where we saw stocks and bonds get sold off together. And basically, people who thought of themselves as being prudent, diversified investors were left with nowhere to hide. It was just right across the board. Since then, things have mellowed out and diversified investors have done a little bit better.

But it does make you wonder whether that was a warning or at least a message that just because you are seemingly diversified, does not mean that some part of your portfolio is always going to work or hedge against the other parts.

Tracy Alloway (3:25)

Absolutely, so we are going to dig in to both those concepts, correlation and diversification. And we have the perfect person who's going to talk about it with us, a guy that's been doing a lot of research on this exact topic. His name is Farouk Jivraj. He is Head of Investment Strategies Research over at Barclays.

Farouk, thanks so much for joining us.

So did we get it right in our intro? Is correlation that difficult for people to model? Is it a sort of ongoing intractable issue in finance?

Farouk Jivraj (4:10)

That's exactly right. I mean, fundamentally correlation, irrespective of where you're measuring it, across asset classes or across stocks, et cetera, is time varying. And I think we're all very familiar with the fact now that it varies through time. Historically, there was an opinion about, in particular between the correlation of stocks and bonds, that they were positively correlated. And over the long run, depending upon the sample of data that you're using, you can find that they were positively correlated during certain periods. But post the 1990s, there was almost a structural break between the relationships of stocks and bonds.

And they became more negatively correlated.

Bonds were seen as almost flight to quality asset when risk was off the table. And so ultimately, we are seeing that there's more variation in that correlation number through time, which means that it's harder to model. It's more difficult as an input into your portfolio construction methods. And there's because of the increase in the market participation, so there's more investors who are trading stocks and bonds in the market from institutional through to retail investors. There's just more noise around estimating this correlation. And so it's becoming an even more sensitive parameter, I would say, in particular, as you mentioned, between stocks and bonds.