Why Isn’t Diversification Working?

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Both stocks and bonds have performed poorly in 2022, and the standard 60% stock 40% bond portfolio has posted one of its worst showings in years. That’s leading many investors to wonder if diversification failed in 2022 and how they can better protect their portfolios against stock market losses. Joining me to discuss the topic is Amy Arnott. Amy is a portfolio strategist with Morningstar.

Hi, Amy. Nice to see you today.

Amy Arnott: Nice to see you, too.

Dziubinski: Let’s start out by talking a little bit about the performance of the 60/40 portfolio this year. Why haven’t bonds provided that shelter that perhaps many U.S. investors expected against stock market losses as we’ve seen this year?

Arnott: Well, it’s been a very tough environment for bonds. We’ve had resurgent inflation, and the Federal Reserve has been aggressively hiking interest rates to try to get inflation under control. So, we’ve had six increases in the fed-funds rate so far this year, totaling about 375 basis points. And so, as a result, bonds have really not provided as much of a cushion as people might have hoped. So, you have long-term Treasuries down as much as 28% through the end of November and broader bond market indexes down about 13% or 14%. As a result, even though bonds have lost less than stocks, they really haven’t provided as much of a cushion as they usually do.

Dziubinski: Let’s look into the crystal ball, Amy. Looking ahead, what do you think is a fair expectation for investors to have for the 60/40 portfolio given where we are in the markets right now? Has that relationship between stocks and bonds really undergone some sort of secular change? And under what conditions might bonds provide that ballast that investors typically associate with them?

Arnott: We really have seen a fundamental shift in the environment. We had a very long period of three or four decades when interest rates were mostly trending down, and this year that has started to reverse. So, because of that reversal, the correlations between stocks and bonds have moved from negative to positive, which means there’s less of a diversification benefit from bonds. The good news is that because interest rates have already increased so much, and the yield on the 10-year Treasury is up significantly, I think bonds are looking a lot more attractive than they did a year ago. So, it still could be difficult if we see continued inflation, continued interest-rate hikes, but I would argue that the worst pain in the bond market is probably over.

Dziubinski: Now, you recently wrote an article on Morningstar.com, did some research, that talked a little bit about why really broad-based portfolio diversification, so that it’s diversification going beyond just U.S. stocks and U.S. bonds, has in fact worked this year. So, let’s start out: How do you define, sort of, broad-based portfolio diversification?

Arnott: Well, if you think about a basic core portfolio, you probably have larger-cap stocks and investment-grade bonds, maybe a little bit of cash. And I would define broader diversification as adding additional asset classes, so things like international stocks, small-cap stocks, real estate, high-yield bonds, international bonds, things like that.

Dziubinski: Let’s take a deeper dive into some of these asset classes beyond that 60/40 portfolio and how they’ve done this year. Let’s start out with some asset classes that haven’t done very well and haven’t really offered as much in terms of diversification.

Arnott: Well, unfortunately, most of these asset classes that people traditionally look to for diversification have not done well. And I think we’re providing a link that people can download. If you look at the chart, almost everything is in negative territory so far this year. So, we’ve seen losses on U.S. stocks, international stocks, real estate, high-yield bonds, global bonds, almost across the board.

Dziubinski: And then, let’s talk about the flip side. What are the pockets that have done pretty well and provided a little diversification value this year?

Arnott: There have been a couple of bright spots. Gold, which is an asset class that people traditionally look toward for as a safe haven, has lost about 3.8% so far this year as of the end of November. So, it hasn’t done maybe as well as people had hoped, but the losses have been relatively mild. Cash is up about 1.1% so far this year, so still losing money after inflation but at least up in nominal terms. And then, commodities have been the real star, with gains of 17% or 18%, mainly driven by rising energy prices.

Dziubinski: Given what we’ve experienced in 2022, what’s worked when it comes to diversification and what hasn’t worked as well, how should investors be thinking about diversification in 2023 and beyond?

Arnott: Well, I think you probably heard me say before that I like to think of diversification as an insurance policy. So, it’s something that you have in case something goes wrong, and it doesn’t always pay off. It’s something that you have to pay for. And in some years, there may be only a small benefit, like there was this year, but even if it’s a small benefit, it’s better than nothing. So, I think, diversification is still a sound strategy and something that people should aim for when they’re putting together their portfolios.

Dziubinski: Well, Amy, thank you for your insights and time today. We appreciate it.

Arnott: Sure. Great to be here.

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