How to Diversify Your Portfolio in 2021

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Investors may struggle with the concept of portfolio diversification, specifically which asset classes they should add to their portfolio if they want to diversify their U.S. stock exposure. Morningstar recently published some new research on the correlations of various asset classes versus U.S. stocks. Joining me today to discuss some of the study's findings are two of the paper's authors: Amy Arnott, who is a portfolio strategist with Morningstar, and Christine Benz, Morningstar's director of personal finance.

Thank you both for being here today.

Christine Benz: Great to be here.

Amy Arnott: Great to be here.

Dziubinski: Christine, let's start by first defining our terms. Can you explain briefly what correlations are and how investors can use them to construct portfolios?

Benz: Sure, Susan. Correlations describe the extent to which the performance of two assets have been correlated with one another. To measure that we use a statistic called correlation coefficient. What you are looking for if you want to build a diversified portfolio is that you'd like to find a negative correlation coefficient. If the number is negative 1, that means that the two assets are inversely correlated. When one goes up, the other goes down. If their correlation coefficient is 1.0, that means that performance is very much in sync, so they have less diversifying abilities with one another.

It's important to remember, though, that correlation coefficient just captures direction rather than magnitude. So, if I have two investments, one goes down 2% and the other goes down 20%, that's a big difference to me as an investor. But correlation coefficient doesn't pick up on that differential. It's just picking up on the fact that they both went down.

Dziubinski: The study that you both were recently involved in looks at the correlations of various asset classes against U.S. stocks specifically. Amy, talk a little bit about why U.S. stocks were really sort of a starting point here.

Arnott: A lot of investors have core holdings in U.S. stocks, and that's also the major type of risk that people are trying to diversify away from. So we used that as our starting point, and we measured correlations against the Morningstar U.S. Market Index.

Dziubinski: As you noted in the report, correlations tend to increase during periods of market stress. Let's talk a little bit about 2020, specifically where we did experience some market stress: What in broad strokes did correlations look like during that period, Amy?

Arnott: We did see correlations increase across most major asset classes early last year during the market turbulence. There were some fairly big increases in correlations, especially in non-Treasury bonds like corporates, municipal bonds, and global bonds, as well as sectors like real estate and utilities. Basically, the trend was investors were selling off any type of higher-risk asset, and that was reflected in the correlation numbers.

Dziubinski: How did what we saw in 2020 with correlations perhaps differ from what we had been seeing for, say, the past decade or two prior to that?

Arnott: For the most part, what we saw in 2020 was really a continuation of previous trends. Overall, over the past 10-20 years, we've seen correlations trending up, and that pattern continued in a number of different areas including equity market sectors, investment styles, factor profiles, and even some alternative investments. Correlations for international markets, commodities, and small-cap stocks remained fairly high as they have been over the past few years, while those of Treasuries and cash remained low.

Dziubinski: Let's dig a little bit deeper into a couple of asset classes that maybe investors have traditionally been using for diversification. Christine, let's talk about bonds first. What types of bonds have been traditionally better diversifiers against U.S. equities, and then, conversely, which bond types haven't done as great of a job when it comes to diversification?

Benz: Amy referenced a couple of them. Treasury bonds have been pretty consistently effective as diversifiers when we look over time periods as far back as the past 20 years. Cash has recently looked a little better as a diversifier alongside Treasuries. A lot of other fixed-income categories have been less effective as diversifiers. Some of them you might not expect to be especially effective. So, the whole category of lower-quality bonds has not served investors especially well as diversification tools. This would include junk bonds, emerging-markets bonds, bank loans. And that's because, as Amy said, people are often getting out of risky assets when they're getting out of stocks, and investors view these fixed-income types as riskier fixed-income assets.

What's a little bit more surprising to me is the extent to which you see not-great diversifying abilities among categories like funds that fall into Morningstar's intermediate core-plus category. These are funds that are generally pretty high-quality but include some lower-quality exposures around the margins. These haven't served investors especially well as diversifiers. But here again, I would point out that magnitude is important, that even though these categories' correlation coefficients with equities aren't necessarily in negative territory, historically they have been able to deliver positive returns during extended periods when stocks have been down.

Dziubinski: Did the historical correlation pattern that we had observed really hold true for bonds in 2020 as well?

Benz: It generally did. We saw Treasuries come through generally very nicely, especially short and intermediate-term Treasuries. Cash, as I mentioned, looked relatively better than it has, and I think that that may simply be that the yield differential between bonds--certainly between Treasuries and cash--is still pretty low today. So, some investors might have viewed cash as a worthy alternative to Treasuries or other bond types simply because they weren't earning that much more by taking on the risk of bonds. Generally speaking, I think we saw a persistence of some of the patterns that we've seen historically.

Dziubinski: Given that, it seems like Treasuries have actually done a pretty good job diversifying both in 2020 and over longer periods. Is it fair--given where the bond market and the stock market are today--is it fair for investors to expect Treasuries to continue to be good diversifiers for, say, the next 10 or 20 years?

Benz: That's a question that was really nagging at us as we worked on this paper because we have experienced a really specific investment environment over the past couple of decades where we've had generally declining bond yields, which is good for Treasuries. We've had very low inflation. And so I think the question in my mind is whether Treasuries' effectiveness as ballast for equities will carry forward into the future in an environment where perhaps we will have rising yields, where we could have more inflation. When we look back to periods like the 1970s and early 1980s where we had higher inflation and higher interest rates, Treasuries weren't quite as effective during that period. But one thing I come back to is that there's quite an intuitive reason that investors gravitate to Treasuries in periods of stock market duress. It's mainly that they're viewed as a store of value, an emblem of quality for investors, and I think that will be persistent. And then, another tailwind for Treasuries in periods of stock market stress is that those periods often coincide with periods of economic weakness. And that's often when we see yields declining, which is good for high-quality bonds. It tends to be a good environment for Treasuries because they're a reflection of whatever is going on in the interest-rate environment. So, I think that those tailwinds are likely to persist unless we see inflation and interest rates move into some really historically greater, higher pattern than we expect to see.

Dziubinski: Now let's pivot over and talk a little bit about international stocks, which are another component that investors often have in their portfolios. Amy, you suggested earlier that international stocks maybe weren't the best diversifiers for U.S. equities in 2020. Talk a little bit about the correlations there.

Arnott: A lot of people think of international stocks as being one of the first places to look to for diversification. But if you look at correlation coefficients, most international markets have actually shown fairly high correlations with U.S. stocks recently. And COVID-19 has obviously had a worldwide impact. So, losses on international stocks weren't really that much lower in early 2020.

Dziubinski: And then, how did that compare again over the longer time frame that the study looked at?

Arnott: If you look back over the past 20 years or so, we've seen fairly high correlations between U.S. and international stocks. If you take a benchmark like the Morningstar Developed Markets ex U.S. Index, it has a correlation coefficient of about 0.9 versus the U.S. market. That's much higher than previous levels if you go back further in history. So, you're not necessarily getting as much diversification value as you might think from international stocks.

Dziubinski: And Amy, what about some other types of investments that people might look to for diversification, like commodities or gold, or alternative investments? How did those all stack up from a correlation perspective? Do they really provide that much diversification?

Arnott: It's really a mixed bag. Gold continued to do extremely well as a safe haven and portfolio diversifier. Alternatives held up pretty well overall. But other types of commodities and real estate had pretty sharp losses in early 2020.

Dziubinski: In general, Christine, to wrap up, given the rise that we've seen in correlations in general over the past couple of decades, how should investors be thinking about portfolio diversification today?

Benz: I think simpler is better. You probably wouldn't be surprised to hear me say that. When we look at Treasury bonds and cash, they have proved to be quite effective as diversifiers for equities. So, even though we've seen correlations in some other areas increase, those two look to be decent diversifiers. And, again, I think it comes back to time horizon, Susan, that investors really need to know their time horizon until they will need their money for spending. If you go through these periods of equity market weakness, which we investors periodically endure, it's really important that you're not a seller in those periods, and that if you are a seller, you probably want to have cash set aside; if there's any reason that you will need to be unloading anything but cash during those periods, it's probably not a great idea. So, I think time horizon can be incredibly informative when thinking about building a diversified portfolio and thinking about maintaining correlations on an ongoing basis.

Dziubinski: Christine and Amy, thank you both so much for your time today. This is a really important part of the portfolio puzzle, diversification. So we appreciate your insights.

Benz: Thanks so much, Susan.

Arnott: Thanks, Susan. Great to see you both.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.