Why More Diversification Doesn’t Mean Better Returns

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton.

The classic 60/40 portfolio has earned a following because of its simplicity and results. Yet, some investors desire to broaden beyond stocks and bonds to other asset classes to get better results. But how do these two portfolios size up against each other? A trio of Morningstar researchers examined that in the 2024 Diversification Landscape report. Amy Arnott is one of the co-authors and a portfolio strategist for Morningstar Inc. Here’s our conversation.

Thanks for being here, Amy.

Amy Arnott: Great to be here.

The Benefits of Portfolio Diversification

Hampton: So, let’s start with a quick explainer about the benefits of portfolio diversification. What should people hope to achieve?

Arnott: The basic idea behind portfolio diversification goes back to the idea of not putting all of your eggs in one basket, so you don’t want to be overexposed to any particular security or asset class. And typically, by holding many different securities or asset classes, you can reduce the risk profile of your portfolio. We measure the potential for diversification by looking at something called a correlation coefficient, which measures how closely two securities or asset classes tend to move in relation to each other. So, if the correlation coefficient is positive one, that would indicate that the two asset classes have moved perfectly in step with each other. So, they’re basically both going up or going down consistently 100% of the time. If the correlation coefficient is zero, that would indicate that they have basically no relationship to each other. And if it’s negative one, that would indicate that they’re perfectly negatively correlated. So, they’re moving in opposite directions.

Practically speaking, it’s very difficult to find asset classes that have negative correlations because most types of assets are affected in a similar way by macro events like changes in interest rates or inflation, overall economic trends. Usually what we’re looking for is securities or asset classes that have a correlation coefficient that’s lower than one. It might still be positive, but lower than one. And the goal of that is to build a portfolio that can hold up well in a variety of market environments.

How Does the 60/40 Portfolio Hold Up Against a Portfolio with More Asset Classes?

Hampton: Your team’s research compared the 60/40 strategy against a portfolio with more asset classes. Can you describe the makeup and why you all chose those assets?

Arnott: We started with a very basic version of the 60/40 portfolio, which was made up of US stocks and US investment-grade bonds, so the biggest asset classes that most investors might be most likely to hold in their portfolios. And then we tested that against a more diversified portfolio. So, we kept the overall mix between stocks and bonds at 60/40, but we added in a variety of subasset classes, so things like international stocks, high-yield bonds, gold, commodities, real estate, etc. And the total number of asset classes was 11. And the reason we chose those is those are the types of assets that people often look to when they’re trying to diversify their portfolio. So, they are some of the most commonly held asset classes.

Hampton: How did the 60/40 and the test portfolio fare against each other in 2023?

Arnott: In 2023, as you know, we had a big rebound in the markets. Stocks were up about 26%. So, because of that, the basic version of US stocks and US investment-grade bonds gained about 18%, but the more diversified version gained only about 14% for the year.

Why the Well-Diversified Portfolio Struggled in 2023

Hampton: And why did the well-diversified portfolio struggle last year?

Arnott: I would say, you know, 14% is still a pretty good return in the broad scheme of things. It just wasn’t quite as strong as the basic version, just because it was such a strong bull market for US stocks that diversifying into most other types of asset classes really didn’t lead to better returns for the year.

Is It Worth It to Invest Beyond the 60/40 Portfolio?

Hampton: So, is it worth it to go beyond a 60/40 portfolio?

Arnott: I think so, especially when it comes to international stocks. International stocks really have not paid off recently. They’ve fallen pretty far behind the US market over the past 10 to 15 years. But if you look back historically, there are still certain periods when international stocks have fared better, like the early 1970s, mid-1980s, if you look at the stretch from 2002 to 2007. I think another reason to diversify into international stocks is just that they do make up such a large portion of the global market. So, if you look at the global market cap, non-US stocks make up about 40% of that. And then the other reason I think for holding international stocks would be to hedge against any potential weakness in the dollar. So, the dollar has been very strong for quite a while, which has helped US stocks and hurt non-US stocks, but that trend could potentially reverse in the future.

Why Interest-Rate Pivots Are Painful but Encouraging

Hampton: The Federal Reserve raised interest rates to a two-decade-plus high to fight inflation. This pulled stocks and bonds’ correlations tighter. Why should investors find so-called interest rate pivots encouraging?

Arnott: When these interest-rate pivots happen, it can be very painful, as we saw in 2022 when bonds had really sharp losses because of the really rapid increase in interest rates. And as a result of that, we’ve seen correlations between stocks and bonds move from below zero to actually above zero for the past couple of years, which means you’re not getting as much of a diversification benefit from holding both stocks and bonds. But even though these types of interest-rate pivots are painful in the short term, as you said, they should be encouraging for investors in the long term.

One reason is that when interest rates get very close to zero, as they were a couple of years ago before the Fed started this series of interest-rate hikes, you’re getting very low returns on bonds just because the yield is so low. And interest rates near zero also mean there is really nowhere for interest rates to go but up, which makes the prospects for future returns lower. And on the flip side, after we’ve already gone through a series of interest-rate hikes, now you have much better yields on bonds, which means the prospects for future returns are better. You also have more of a cushion from that yield if the equity market goes through some sort of downturn. And then eventually, after you go through that period of pivoting and resetting, eventually that environment will change. So, we’re in a period of a lot of interest-rate uncertainty right now, where the Fed has been not cutting interest rates as quickly as a lot of people thought. But eventually that will change, and we’ll see interest rates eventually stabilize and decline, which would be positive for bonds.

Is There an Interest-Rate Pivot Right Now?

Hampton: So, are we in an interest-rate pivot right now?

Arnott: Yeah, I think we definitely were in an interest-rate pivot in 2022 and 2023. We haven’t had as many interest-rate increases recently, but interest rates have been remaining at a higher level. So, I think we’re still in a period of significant interest-rate uncertainty, especially given that inflation is still higher than the Fed would like.

Do Bonds Still Provide a Diversification Benefit?

Hampton: Can you talk about whether bonds are still worth holding as portfolio diversifiers?

Arnott: As you mentioned, during these periods of interest-rate pivots or interest-rate uncertainty, you tend to see correlations between stocks and bonds increase. So that means you’re not getting as much of a diversification benefit from holding bonds as in other periods. But I would point out that even though there is less of a benefit, there is still a benefit. So even if you have correlations around 0.6 or 0.7, which is where they’ve been for the past three years or so, you’re still getting a pretty significant diversification benefit from holding both stocks and bonds. And you’re also, if the market were to go through some sort of shock or equity market downturn, especially now that yields are higher on bonds, you should get some cushion from holding fixed-income securities.

Which Bonds Are the Best Portfolio Diversifiers?

Hampton: Which bonds make the best and worst diversifiers?

Arnott: I would say the best would be cash. And the reason behind that is because the interest rates are basically resetting immediately, so you’re really not exposed to the stock market at all, which makes them the best diversifier, which is something that we saw in 2023. Investment-grade bonds, especially Treasuries, would be the second best in my opinion. And that’s because, as I mentioned, even though correlations have increased, they’re still relatively low. And then once you get into corporate bonds and high-yield bonds, especially, the diversification value is much lower. So, for high-yield bonds, especially because they have weaker balance sheets, they’re more sensitive to overall economic conditions. They tend to act more like stocks than bonds, which means they have a higher correlation with stocks and less diversification value.

The Role of Cash in an Investment Portfolio

Hampton: And you mentioned cash. What about that in a portfolio? Should investors make room for it?

Arnott: It really depends on your goals and your time horizon. I think if you are someone who is in retirement or approaching retirement, you definitely want to hold at least one or two years’ worth of living expenses in cash. And even if you’re a younger investor, if you’re trying to build up an emergency fund or saving up for a down payment on a house or some other sort of near-term goal, you probably want to have those assets in cash or some other type of very liquid short-term investment. And then for other investors, even if you have a longer time horizon, I would argue that now that yields on cash are 5.4% or 5.5% as we’re taping this toward the end of May, I think it’s definitely worth carving out a portion of your fixed-income portfolio for cash and shorter-term bonds.

Key Takeaways

Hampton: What’s the message you want people to keep in mind?

Arnott: One key thing is that diversification is important, but you don’t necessarily have to own every single asset class. I think if you go with a pretty simple three-fund portfolio with US stocks, US bonds, and international stocks, that can give you a pretty solid foundation for building a diversified portfolio. And another point I’d make is that diversification doesn’t always lead to better returns. It’s more like an insurance policy and a way of reducing risk in your portfolio.

Hampton: Those are good reminders. Thank you, Amy, for coming to the table and sharing your research.

Arnott: Thanks for having me.

Hampton: That wraps up this week’s episode. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to Senior Video Producer Jake VanKersen and Associate Multimedia Editor Jessica Bebel. And thank you for watching Investing Insights. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.