Skip to Content
US Videos

Diversification Deep Dive

New research suggests that diversifying a portfolio is becoming more challenging. Here's what to focus on.

Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar. New research suggests that effectively diversifying your investment portfolio may be becoming more challenging. Joining me today to discuss some of the findings from Morningstar's 2022 Diversification Landscape Report are the paper's three authors: Amy Arnott, who is a portfolio strategist with Morningstar; Christine Benz, who is Morningstar's director of Personal Finance and Retirement Planning; and Emory Zink, an associate director with Morningstar's Manager Research team. Thank you all for being here today.

This portfolio diversification research that you all have done examines the correlations of various asset classes against U.S. stocks. So, let's begin our conversation with you, Emory, and talk a little bit about what correlations are and how they're used in portfolio construction.

Emory Zink: When we think about, kind of, measuring the diversification within a portfolio, there are plenty of different statistics and measures that one can use. We decided to use correlation because it's very straightforward. In the context of this study, correlation is to what degree do two holdings within a portfolio, kind of, move together? And so, correlations, they range from negative 1 to 1--positive 1. So, a correlation of two holdings that have a positive 1, they'll move in tandem; one moves up, the other moves up. If it's zero, it means there's no relationship. If there's a negative 1 correlation, then when one moves up, one tends to move down. And what we're really looking for is that negative correlation, because when you're looking at a total portfolio, if you have some things moving up and some moving down, that means that when there's an aggressive selloff, say, in U.S. stocks, that there's going to be kind of a muffle to that volatility. It's going to increase the risk-adjusted returns of the overall portfolio. This is one of those instances where, kind of, the whole portfolio is worth more than just the individual sum of its parts.

Dziubinski: Emory, you mentioned U.S. stocks, and your research was looking at the correlations between different asset classes against U.S. stocks. So, Emory why was sort of the home base here U.S. stocks for purposes of your study?

Zink: Yeah. So, the study is written, sort of, from the perspective of a U.S. investor. But it's also kind of really interesting that we would start with U.S. equities. That's like 60% of the global market cap. Equities are very easy to access, and they're kind of well-articulated, their characteristics. So for most investors, that's just an easy starting point. From there, you can add asset classes in or take them out, and then really just sort of adjust the characteristics of your overall portfolio. So, you get the profile that you want. So, it just sort of seems the easiest entry way point for the discussion.

Dziubinski: Let's talk a little bit about correlations in 2021. Amy, what were your findings?

Amy Arnott: What we saw is that in 2021 correlations actually decreased for a lot of major asset classes when measured against U.S. stocks. But at the same time, it was a very bullish market environment for most of the year. So, you had stocks up about 26% for the year. So, because of that, diversifying into bonds did not improve returns in 2021. Adding other asset classes that people often look to for diversification value, like international stocks and gold, also didn't improve performance.

Dziubinski: Then, how did what you saw in 2021, Amy, compared to say the prior decade? Were the trends the same? Did they change at all?

Arnott: If you look back over the period from 2011 to 2020, bonds were much better diversifiers. So, if you added bonds to an all-equity portfolio, you would have reduced your returns slightly. But overall, there was also a significant decrease in risk. So, risk-adjusted returns were significantly better. And that was also the case during 2020, especially when we had the market correction in February and March. It's interesting that actually the most generic type of diversified portfolio, just a simple mix of large-cap stocks and investment-grade bonds, actually did really well in terms of adding diversification value and improving returns over that 10-year period.

Dziubinski: Amy, tell us how did what you found last year compared to trends you had seen the prior decade?

Arnott: If you look back at the period from 2011 to 2020, bonds were actually much better diversifiers. Adding bonds to an equity-only portfolio would have reduced your return slightly, but also really significantly decreased risk. So, overall, you ended up with better risk-adjusted returns. And that was also the case specifically during 2020, especially during the market correction in February and March. One interesting thing is the most generic type of diversified portfolio, what people often refer to as a 60-40 mix of large-cap stocks and investment-grade bonds, actually did very well during that 10-year period. So, adding a lot of specialized asset classes, like international stocks, or commodities, or gold, didn't necessarily improve your results as much as just a plain-vanilla mix of stocks and bonds.

Dziubinski: So, let's talk a little bit about the asset classes that investors often do turn to when they're seeking out portfolio diversification, the first being bonds. Christine, let's do a little bit of a deep dive there about what types of bonds have been traditionally better diversifiers than others and how did those bond types actually do in 2021 from a correlation perspective?

Christine Benz: Well, long-term, Treasury bonds have been the best diversifier for equity exposure. We've seen this pattern over the past couple of decades. The reason is pretty intuitive that in equity market shocks--that's typically a flight to quality where investors want something safe. They want the sure thing, and Treasuries have beckoned in those environments. And then, another force behind Treasuries in those environments is that the Federal Reserve is often lowering interest rates or interest rates are drifting downward during those periods, and that provides a tailwind for Treasury prices. So, Treasuries have been the best diversifier.

The pattern was a little bit different in 2021, where we saw--especially, toward the end of the year, we saw some pressure on bond prices, especially intermediate-term and long-term Treasuries. So, they weren't the great diversifiers in the second half of the year that they have been historically, in part because stocks and Treasury bonds were bugged by the same thing. They were worried about these impending Fed rate increases, Federal Reserve rate increases. And so, that force dragged on both equities and bonds at the same time. That's not something we've seen recently. But short-term Treasuries did in fact do pretty well in 2021 as a diversifier for equity exposure.

Dziubinski: So, then, let's sort of look at the other side of that, Christine. Which bond types have not been great diversifiers historically, and then, how did those look last year?

Benz: Yeah. I think, at the top of the list in terms of categories, fixed-income categories, that have not been great diversifiers for equity exposure—high-yield bonds, emerging-markets bonds, floating-rate loans, multisector bond funds--any of the sort of higher income, higher yielding, lower-quality fixed-income types, those haven't done a great job of diversifying equity exposure, which I think to me sort of makes the point that if you hold them, think of them as kind of lower-risk equity alternatives, rather than things that act really bond-like in an equity market shock. Somewhat surprising to us as we looked at the data was that some of the core fixed-income types that investors hold, such as intermediate-term core plus funds, even short-term bond funds, municipal bond funds, they are not as beneficial as Treasuries from the standpoint of diversification and correlations. They tend to behave a little bit more in sync with the equity market. But that's certainly in relative terms, that they've sometimes had these price dislocations in equity market shocks. But if you hold them with a reasonably long time period in mind, say, three to five years, you probably will experience nice diversification from equities. But over those shorter time periods, that's where we sometimes do see price dislocations in those bond types. They're just not as strong from a diversification standpoint as Treasuries have been.

Dziubinski: Christine, what about cash? How does that fit in here? How historically has that worked as a portfolio diversifier? And then, how did it sort of look last year?

Benz: It's interesting, Susan, because historically, cash hasn't been as strong as Treasury bonds from a diversification standpoint. And that makes sense because as a cash holder you're not going to experience any fluctuation in your principal, even to the good side, as you might with some sort of a bond investment where you might experience a price increase when stocks are going down. But one thing we've seen very recently is that cash has looked somewhat comparable to Treasuries from the standpoint of diversification. And that may be because the yield differential between Treasuries and cash is so limited, that perhaps cash has looked a little bit better from a diversification standpoint.

Dziubinski: So, Amy, let's pivot over to international stocks, which you alluded to earlier, haven't necessarily been the best diversifiers for U.S. equity portfolios. Why is that?

Arnott: The problem is that non-U.S. stocks have fallen behind U.S. stocks by a pretty wide margin in nine out of the past 10 calendar years, and if you look at that full 10-year period, the performance gap is about 9 percentage points lower on average. So, that's really a huge return gap. So, adding an international allocation to a U.S. equity portfolio didn't improve returns or risk-adjusted returns. In addition, we've seen a trend of generally rising correlations for international stocks as markets and economies become more globalized. So, international stocks didn't improve portfolio results as much as they usually do from that perspective, either.

Dziubinski: What if you just, sort of, carved out and looked at emerging markets specifically, Amy? Did they provide any more of a diversification value as far as you saw?

Arnott: So emerging markets are often driven by country-specific or industry-specific factors. We have seen a lower correlation between emerging-markets stocks and U.S. stocks. So, for emerging markets, the correlation coefficient over the past three years has been about 0.83 versus 0.93 for developed markets.

Dziubinski: So, now, bonds and international stocks are often what many people think of as, this is how I diversify my portfolio. But there are sort of smaller types of investments that some investors will also use for diversification, and among those is commodities. Emory, let's talk a little bit about that. What did we see in terms of correlations between commodities and U.S. equities last year and in the prior decade?

Zink: I think what's kind of interesting when we look at commodities is, historically, they've been priced based on kind of a supply/demand dynamic. So, when you're looking through your finance textbook, and somebody talks about commodities as a diversifier to U.S. equities, that's because the investors could--you know, there might be some surprises, but look at the supply and demand dynamics, and it would perform very differently than equities. Oftentimes, we hear commodities are referred to as a great inflation hedge, because changes in prices as they rise are reflected pretty immediately.

But when we're looking at 2021, not only was there a greater demand for commodities because inflation was rising, but there were some other factors at play there. So, we're talking about the supply/demand dynamics. You have things like geopolitical risks that were really affecting, say, the supply of oil. There was also increased demand for things like copper or cobalt, which were inputs into electric car batteries and various products that are in high demand right now. So a lot of these factors are shaping and reshaping the commodities landscape, and so for that reason, there's been increased volatility. When we, kind of, look at that diversification of traditional basket of commodities relative to U.S. equities, it spiked a bit. So, it's higher than it was previously. But they do provide some diversification still.

Dziubinski: And Christine, a couple of other areas that investors might turn to in an effort to diversify are REITs and gold. How did both of those stack up, both sort of last year and as longer-term? Have they been good diversifiers?

Benz: REITs have been seeing a decline in the diversification benefit that they might add to an equity portfolio. Many investors own U.S. equities, bonds, and a small allocation to REITs, and they might want to continue to do so for income reasons or valuation reasons. But there doesn't appear to be a strong case for doing so through correlations and diversification. Gold is a little bit of a different story. And it really depends on the way in which you approach a gold investment. Precious metals equity, which is a way that a lot of investors own gold--so, these would be gold-mining companies and companies that mine other metals. When we look at the correlations, they are lower than other equity categories, but they are somewhat positively correlated with the equity market, the broad U.S. equity market. Gold as a commodity, whether gold prices or a gold ETF tracker like GLD, we did see a little bit less of a correlation with equities. So, it appears that that is a somewhat better equity diversifier than precious metals equity.

Dziubinski: Amy, let's talk a little bit about what people refer to as “digital gold,” which is cryptocurrency. Though this is still relatively new for many investors, how has cryptocurrency performed as far as diversification value goes both, again, last year, but over the longer term as well?

Arnott: There's obviously been a lot of hype and excitement about cryptocurrencies in the past couple of years. And cryptocurrency is actually fundamentally different from most other asset classes in the sense that there are no underlying cash flows, which can make it very difficult to value, and it's an asset that exists purely in digital form. So, it's very different, for example, from the commodities that Emory was just talking about. So, because of that, the correlations between cryptocurrency and almost any other asset class has been extremely low. At the same time, another important trait of cryptocurrency is it's extremely volatile. And so, that volatility is, in fact, so high that it can completely overshadow the diversification value. So, for example, last year, we had bitcoin increasing 100% in the first quarter and then losing 40% of its value in the second quarter. So, that type of volatility--even though theoretically, cryptocurrency could be a good portfolio diversifier, the volatility, I think, makes it very difficult for a lot of people to use effectively in a portfolio.

Dziubinski: And then, Amy, if more people did start using cryptocurrency in their portfolio, do you think that would have any impact on the correlations? Would it become less effective as a diversifier?

Arnott: Absolutely. And in fact, we have already seen correlations increasing for cryptocurrency versus other asset classes like U.S. stocks, and that's especially true during volatile markets. So, if you think about it, cryptocurrency is really sort of the ultimate risk-on asset. So, that really is the key driver of performance more so than correlations.

Dziubinski: Emory, in the report, when you're talking about alternative strategies, you specifically say that they offer something fundamentally different from mainstream asset classes. But you also point out in the report that there are a lot of different alternative strategies that managers will pursue. Are there particular ones that you've found over time that provide more diversification value than others?

Zink: So, alternative strategies are really, sort of, difficult to talk about, and for that reason, we weren't even using alternatives benchmarks. There's such a variety that we ended up actually using the Morningstar Categories. Of the seven that we looked at, there were two that had low correlations with U.S. equities. One was equity market neutral, where the strategy aims to kind of cut out and have returns that are completely independent of the equity markets. And the other is systematic trading, where there's a really broad investment menu. They're potentially investing in things like commodities, currencies, fixed-income, many of the asset classes that we've been discussing here today that they have low or negative correlations with U.S. equities.

With alternatives, in those two options, you have the possibility of diversifying your portfolio. They have low correlations with U.S. equities over 2021. But I would caution any investors, when you're thinking about investing in alternatives, you really want to know what it is that you're getting. Because they are so unusual, and you want to make sure that whatever it's offering your portfolio, it's surfacing in the ways that you want it to.

Dziubinski: Let's take a step back now away from particular asset classes and types of investments that investors might seek out for diversification, and instead talk a little bit about the purpose of diversification. Amy, we always say that the goal here is to really improve your risk-adjusted results by diversifying. But does diversification always do that?

Arnott: That's a great question. As Emory mentioned at the beginning, the way the math of diversification works is anytime you have a correlation coefficient lower than one that can potentially reduce the portfolio's risk profile, and the lower the correlation coefficient, the greater the risk-reduction benefit. But if you're trying to improve risk-adjusted returns, returns are obviously a big part of that also. So, if you diversify into an asset class that turns out to have lower returns, that could end up hurting your results in the short term. So, it's sort of like carrying an umbrella. If you think it's going to rain, if it does end up raining, you're going to be very happy you had the umbrella. If it turns out to be a nice, warm, sunny day, you might be kind of annoyed having to carry this umbrella around all day when you didn't really need it.

Dziubinski: Now, you also examined in this report, Amy, what impact inflation might have on correlations. Because again, the time period you were looking at really was a period of pretty low modest inflation, which it's kind of a different picture today. So, what are some things investors might be thinking about when it comes to diversification when inflation is higher?

Arnott: Right. So, we looked at some specific periods, when inflation increased by at least 5% and remained high for at least six months. So, these were periods like the late 1960s and early 1970s, for example. What we found in that type of environment is you do typically see correlations between stocks and bonds increase. That's a big contrast from the past 20 or 30 years when we've had generally declining interest rates, below-average inflation until very recently. And those conditions led to negative correlations between stocks and bonds. So, if we do see a prolonged period of higher inflation, you probably would see correlations between stocks and bonds stay in positive territory, which means there's less of a benefit from diversifying into bonds. But I would point out that it's less of a benefit, but it is still a benefit. So, it's not an argument to say you should get rid of all your bonds, because you're still getting diversification value, and especially risk reduction, which can be very important for a lot of people.

Dziubinski: Now, Amy alluded to the fact that for the past couple of decades we've enjoyed this period of falling or somewhat flat interest rates, right? But now, again, we're moving into an environment where we're expecting rates to be going up. So, Emory, again, based on what your research shows, what might investors be thinking about when it comes to diversification and a rising interest-rate environment?

Zink: I would probably reinforce some of the things that Christine had mentioned when she was talking about bonds and Amy as well when she was discussing the behavior of bonds, partially because we looked at the 70 years of history, and we looked at various periods of rising and falling interest rates. When you're considering a 60-40, kind of, stock/high-quality bond mix, over time interest rates are going to change. So, in decades where interest rates were rising, just given bond math, the high-quality bonds have more duration or interest-rate risk, and those experienced more volatility, and more volatility means they're slightly more correlated with U.S. equities. So, in decades like the 70s, the 80s, and the 90s, you're going to see those correlations increase. But I would note, even though they do increase, they're still much lower than many of the asset classes that we've talked about here today. So they still do provide some diversification.

And then, there are decades like the most recent aughts and the teens, where you had falling or very low interest rates, and in those periods, in those decades, you had negative correlations. So, really, what I would say is, for any investor that's really worried about this rising rate environment, you got to be in it for the long haul. Just consider the fact that over many, many years, when there's a spike in interest rates, you're going to have an increase in correlations between stocks and bonds, or securities that are very interest-rate sensitive. And when interest rates are placid or falling, hopefully, you're going to have lower negative correlations. And over the long run, it's providing diversification to your portfolio and that's what we all want.

Dziubinski: So, Christine, back to you to sort of wrap things up for us, given this research that you all have done and given the backdrop of rising rates and hot inflation, how should investors be thinking about portfolio diversification today?

Benz: Well, I think it's worth plugging into how they might change in an environment of rising inflation, rising interest rates. But I think it's also important to remember that those are just two risk factors that investors face and that equity investors have seen periodically these macroeconomic shocks, recessionary environments where the safe assets, the Treasury bonds and cash that they might hold in their portfolios, have been really good counterweights to equity exposure. So, I guess I wouldn't get fixated on just inflation risk, just interest-rate risk. Remember that there are a number of different risks that you're trying to defend against. And there might be environments where, as Amy and Emory have both said, where bonds will be very valuable indeed. So, I do think that thinking about a balanced portfolio, thinking about your life stage and your proximity to needing your assets to draw upon should be key guideposts as you think about positioning your portfolio today.

Dziubinski: Well, I'd really like to thank all three of you for your time today--diversification is such an important topic for investors--and to really take the time to dig into your new research. We really appreciate it. Thank you.

Benz: Thank you, Susan.

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

Learn more: Morningstar's Diversification Landscape 2022