In the two previous posts, I covered what stocks are as an asset class and what bonds are as an asset class. In this post, I’ll be covering the relationship between stocks and bonds and what that means for you as an investor.
To begin, I’d like to draw your attention back to two statements I made, one in each respective post:
- We invest in stocks as an asset class because they have historically been the most reliable way to generate a significant amount of return in an investment portfolio over the long term.
- We invest in bonds as an asset class because they have historically been the most reliable way to generate a relatively small amount of return in an investment portfolio over the long term while simultaneously providing stability to the portfolio during volatility in the stock market.
You’ll notice the similarity in the wording of each of the two statements. That was intentional, as I wanted to draw a parallel between the two in such a way that it would be clear that there is a relationship between stocks and bonds as asset classes.
So let’s talk about how they relate to each other and how that affects your decisions as an investor.
A Bit of Asset Allocation
I don’t want to dive too deeply into asset allocation on the whole just yet, as that’s worthy of its own post or posts, but I do need to discuss it here to the extent that it helps explain why we talk about “stocks and bonds” collectively as the building blocks for a portfolio and not just stocks or just bonds.
You want your portfolio to grow over the long term. Right? Nothing profound there. Everyone wants his or her portfolio to grow. That’s the name of the game in investing.
But how that portfolio grows, and by how much that portfolio grows, is going to be determined by what’s in it. One stock? Multiple stocks? One stock mutual fund? Multiple stock mutual funds? One bond? Multiple bonds? One bond mutual fund? Multiple bond mutual funds? Some combination of these?
That’s where asset allocation comes in. Again, while we’ll deal with asset allocation in more depth later, what you need to know for now is that asset allocation essentially boils down to deciding what to put in your portfolio and why.
Insofar as we consider stocks and bonds to be their own asset classes, we ask ourselves questions like the following: (1) “What percentage of my portfolio should be in stocks, and why?” (2) “What percentage of my portfolio should be in bonds, and why?”
The answer to both questions is “It depends,” and many of the reasons it depends are for later discussions of asset allocation. However, one thing the answer is dependent on is the relationship between stocks and bonds. When we talk about the relationship between stocks and bonds, we’re talking about a concept in investing referred to as “correlation.”
Correlation is a mathematical concept before it is an investing concept. It is the degree to which two variables move in relation to each other.
On the investing side and as applied to assets, we’re talking about the degree to which two different assets move in relation to each other. So with stocks and bonds specifically, we’re talking about the degree to which stock prices (on the whole) and bond prices (on the whole) move in relation to each other over a specific period.
Good news: You don’t have to do any of the required math yourself, as that’s part of the job of investment professionals. Instead, we’re simply going to glean insights from the work these professionals have performed and use the insights to help us make better investing decisions.
How Are Stocks and Bonds Correlated?
The tricky part about trying to explain how stocks and bonds correlate is that such correlation isn’t static: It doesn’t stay the same across all periods, and the shorter the period measured, the greater the fluctuation in how correlated stocks and bonds are.
But as I’ve said previously on this blog, we think long-term because true investing is a long-term endeavor. Generally speaking, what happens to investments over the short term shouldn’t concern long-term investors all that much (unless you’re nearing retirement, but that’s another blog post).
Consequently, when it comes to the relationship between stocks and bonds, we shouldn’t really care all that much about how correlated they may or may not be over the short term. Instead, what we want to know is how they correlate over the long term. (For the more advanced out there, yes, I know that there are instances in which short-term correlations between assets do matter, but I’m intentionally simplifying.)
I’ll try not to get too technical here. The long-term correlation between stocks as an asset class and bonds as an asset class is near zero. What this means, practically speaking, is that while stock prices have fluctuated significantly over the long term, bond prices have not really fluctuated all that much in relation to stock prices.
For the long-term investor (you and me), this is good, because it shows that bonds as an asset class provide stability to the portfolio, as their prices do not significantly respond to stock market movements over the long term.
What Should We Do with This Information?
So now that we know that the relationship between stocks and bonds is such that they are non-correlated over the long term, what do we do with that information? Is it just simply knowledge, or is it actionable in some way?
The best thing we can do with this information is to put it to use in our ultimate asset allocation decision. And while there is certainly more to asset allocation than just this knowledge about the relationship between stocks and bonds, at the very least, this knowledge shows us that at some point, we need to begin incorporating bonds into our portfolio in order to stabilize our long-term returns, given the volatility of the stock market.
If we can assume that what has historically transpired between stocks and bonds has been built on the fundamentals of each as an asset class, then we can reasonably assume a similar relationship over the long-term future.
Of course, there are no guarantees with investing. But we don’t invest blindly; we first examine what happened in the past to see to what extent it might also apply to the future. Then we act accordingly.
Bottom line: While stocks fluctuate wildly at times, bonds generally do not dramatically swing up or down when stocks do. And that’s exactly why we need them in our portfolio as we progress further into our investing lifetime.
