How Correlation Can Dilute Diversification

March 8, 2024
Positive correlation between stocks and bonds is currently forcing investors to find portfolio diversification elsewhere.

For most of the past quarter-century, U.S. stock and bond prices have tended to move in opposite directions. This negative correlation helped diversified investors offset a decline in stocks with a rise in bonds and vice versa.

However, the past few years saw a marked shift in this relationship, with stock and bond prices becoming more closely aligned than at any point since September 1997.1 Over time, correlations can shift, and this isn't unusual. "But when correlations turn positive, investors question the benefits of diversification," says Liz Ann Sonders, Schwab's chief investment strategist. "That may not be a problem when both asset classes are going up, but it's extremely painful when both are going down."

Much of this positive correlation can be attributed to rising inflation, which forced the Federal Reserve to aggressively hike interest rates. The swift and steep rise in the federal funds rate sent bond yields soaring and bond prices—which generally move in opposition to yields—reeling. At the same time, concerns about a recession caused stocks to founder for much of 2022.

Despite expectations of up to six rate cuts2 in 2024—which could help stocks and potentially shift correlations back into negative territory—Liz Ann doesn't think the Fed's in any rush to start cutting rates for fear of reigniting inflation. "As successful as the Fed has been at taming inflation without triggering a recession, we're not out of the woods yet," she says.

Until then, investors shouldn't rely solely on broad-based stock and bond index funds for diversification; instead, they should also look for ways to add more diversity within those classes:

  • For stocks, "focusing on factors that tend to drive a company's returns—such as high quality, discounted valuations, and low volatility—can add a level of diversification that a traditional asset class–based approach may not," Liz Ann says.
  • For bonds, investors might consider actively managed funds to help navigate the volatile terrain. Otherwise, investors can focus on the other attributes of bonds in a portfolio—capital preservation and income generation. If bonds make sense for your financial plan, then stay the course with them.

Research actively managed bond funds using Schwab's Fund Screener. Select Index Fund under Basic, then select No. From there, you can screen by analyst ratings, expense ratio, fund category, and more.

1Charles Schwab with data from Bloomberg, as of 11/30/2023.

2Morningstar, as of 12/14/2023.

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