No Correlation: Why Stocks and Bonds Don’t Always Move Together
We have often said in this space that diversification means you always own something you hate. A more technical way to define diversification is owning assets that have little correlation with each other. Ideally, you don’t want to own things that move in the same direction at the same time.
One of the most powerful principles in investing isn’t picking the “best” investment, it’s combining different investments that behave differently over time. That’s where the relationship between stocks and bonds (and other asset classes) becomes so valuable. You may have heard that stocks and bonds are negatively correlated, meaning when one goes up, the other goes down. While that has often been true historically, the reality is more nuanced.
Correlation is simply a measure of how two investments move in relation to each other.
Historically, the correlation between stocks and high-quality bonds has generally been low or negative, making bonds an effective diversifier during periods of stock market stress. Stocks and bonds often (not always – most recently, 2022 was an exception) move differently.
The chart below illustrates different bond types and their correlation to each other as well as to the S&P 500.
Because different economic forces drive each asset class, they often respond differently to market events. For example, during periods of economic uncertainty, investors frequently move money from stocks into U.S. Treasury bonds. This “flight to quality” can push bond prices higher while stock prices fall.
Stocks represent ownership in companies. Their returns are driven primarily by:
- Corporate earnings
- Economic growth
- Investor confidence
Bonds are loans made to governments or corporations. Their returns are influenced largely by:
- Interest rates
- Inflation expectations
- Credit quality (rating of the bond)
High quality bonds are often a sought-after safe haven in the face of uncertainty. However, bondholders will still experience price fluctuation, but usually not as much fluctuation as the stock market. So far this year, there has been a slight decrease in high quality bond prices (disappointing conservative investors); this is mostly due to the interest rate environment as well as the recent strength of the stock market. The good news for bond investors is that they are still enjoying a reliable interest rate payment while enduring a slight decline in prices.
Much like the weather and outdoor activities, high quality bonds and stocks are generally not correlated. Those of us that attended the fireworks out in Sperryville this year certainly wished there was a positive correlation between the weather and our plans!
