Invert, always invert: Will Stocks Diversify Bond Investments in the Future?

Invert, always invert: Will Stocks Diversify Bond Investments in the Future?

June 17, 2016 Research Insights, Guest Posts
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(Last Updated On: June 17, 2016)

My last post, “Will bonds deliver crisis alpha in the next crisis?,” created quite a stir on the blogosphere. The underlying assumption of the analysis is that stocks are a core component of a portfolio and bonds are included to diversify the portfolio. The key takeaway from my analysis is that the crisis alpha associated with bond exposures seems to be driven by the income component of bond returns. The implication from the analysis is that bonds may provide less crisis alpha in the future because they have a low level of income at current yields (i.e., 10-year Treasury bond YTM is 1.57% as of 6/16/2016!).

In other words, past performance may not be indicative of future performance.

Asking a Different Question: Will stocks deliver crisis alpha…for bonds?

I gleaned a few insights after sharing the research. First, the post inspired way more conversation than I expected. And second, the follow-on conversations inspired more questions that still need to be answered. For example, Rick Ferri, the founder of PortfolioSolutions, embodied the classic Charlie Munger advice to “invert, always invert” when he mentioned that bonds might BE the next crisis.

With Rick’s thought buried in my brain, I wanted to ask the question, “Do stocks diversify bonds?”

The first task in answering the question, Do stocks diversify bonds, is to define what we mean by “diversification.”  For this question, we will look at the fifty worst months of excess returns (total return minus the return of cash) for bonds and study the performance of the US stock market during those fifty worst months. I try to avoid the use of the term “crisis alpha” so that it continues to mean times of really bad stock market returns:  many people would not define a “crisis” as when the bond portion of their portfolio performs unusually poorly…that just doesn’t seem as scary.  If US stocks perform well when bond returns are bad and the performance of US stocks is consistently positive when bond returns are bad (i.e., positive excess return in more than 50% of months), then it might be safe to conclude that stocks provide good diversification for bonds.

Data Used

For this analysis we use Ibbotson Associates Long-Term US Government Bond TR index for bonds (~20 year duration), Ibbotson Associates US Large Cap Stocks TR index for stock returns and Ibbotson Associates 30 Day T-bill TR for the return of cash.   Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Unless otherwise specified, all monthly returns are arithmetic averages and all returns are excess returns (total return for the month less the return of cash for the month or “ER”).  The data period is from 1/1926 to 4/2016.

Bad Times for Bonds

Although the definition of a bad month for bond returns might vary, we use the worst fifty months.  Since there are 1,084 months in the date range, we are looking at the bottom 5% (rounded) of historical bond returns.

If you are like me, I was expecting to see a lot of months in the later 1970s and early 1980s, which might make any conclusion from this analysis suspect.  Surprisingly, that isn’t the case.  I show the frequency of bad bond months by year in the graph, below:

Count of Bad Bond by Year
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

As you can see from the graph, 1980 and 1981 were a bad time for bond returns.  However, the bad months for bonds are pretty evenly spread throughout history.

So what have “bad months” for bonds looked like return wise?

50 Worst Bond Months
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The single worst month was January 2009 with an excess return of -11.24%–that is pretty surprising!  There are several more months with excess returns between -9% to -6% and then the rest of the bad months have excess return of -5% to -3.5%.

US Stock Performance During Bad Months for Bonds

Historically, stocks have averaged an excess return of -1.66% during bad months for bonds with only 20 of the 50 months producing positive excess returns.  I show a graph of those stock returns, below (the dates are in the same order as the graph, above):

Stock Returns During 50 Worst
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

We see that the negative excess returns for stocks isn’t dominated by a handful of really bad months and it isn’t contained to a particular period of time.

These results highlight that stocks are a reasonable diversifier when bonds have bad months.  When bonds are bad, stocks are often bad, on average. All that said, stocks do not provide a slam-dunk diversification benefit for bond holdings (i.e., strongly negatively correlated).

Implications for Investors

This is (obviously) not a comprehensive list of implications, but are some of the first ones that cross my mind:

  1. If bonds are the next crisis, traditional stock and bond portfolios may perform poorly irrespective of the stock and bond allocation mix.
  2. This analysis would certainly make me a bit more skepitcal of risk parity or min-variance algorithms that typically load up and/or lever on bonds.
  3. If the diversifier in your portfolio (bonds) have a bad month and your return generator (stocks) tends to perform poorly at the same time, is your portfolio really diversified?
  4. If stocks and bonds tend to have poor performance at the same time, this indicates that they may share a non-diversifiable common risk factor that generic correlation analysis doesn’t highlight.

Unfortunately, the analysis above highlights that we may need to think harder about asset allocation in the future. Ideally we make things as simple as possible, but this is not always possible. A generic 60/40 portfolio may not provide the answer to portfolio problems like it has over the past 30 years. Portfolios should probably seek broader diversification, when possible, and if the fees/taxes/liquidity can be managed effectively.


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Please remember that past performance is not an indicator of future results. Please read our full disclosures. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.


Definitions of common statistics used in our analysis are available here (towards the bottom)




About the Author

Andrew Miller CFA, CFP

Andrew Miller, CFA, CFP: Andrew is Chief Investment Officer at Miller Financial Management, LLC where he is primarily responsible for investment and financial planning research, asset allocation, and integrating client’s financial plans with their investment portfolio. Andrew is a Chartered Financial Analysis and is a Certified Financial Planner® practitioner. Andrew graduated from the Indiana University Kelley School of Business in 2004 with a Bachelors degree in Business Administration with a concentration in Finance. Andrew’s research interest is in using academic investment research to create investment portfolios that improve the withdrawal rates and financial outcomes for clients.


  • Armando Fabia

    Andrew, for completeness, will an analysis of stock performance for all negative bond returns in your study period produce a different result?

  • Andrew Miller

    I would imagine that using all negative results would be closer to using correlation as the measure of diversification. This analysis used the really poor results so that the results weren’t overwhelmed with small negative numbers that could be due more to randomness than actual changes in yields/prices.

  • Hannibal Smith

    Interesting! I would like to see some further analysis but focused on duration instead of maturity. Duration is not fixed and has dynamically varied from a high in 1940 to the low in 1980 back to a high at present. It’s my hypothesis that there may be an optimal Treasury duration to always hedge equities; it may be a fixed duration or it may need to match equities’ own duration. Quant duration models say to have no more than four years of duration exposure at present levels of yields. But it is questionable whether such a low duration would offer enough hedging protection. Let’s see some stats!

  • dph

    I’d like to see how commodities (ie gold/ oil) did when bonds were way down? Also how did they do when stocks were down. Maybe break it out US and ex US style if possible.

  • Ritzy

    Can we say bonds diversify stocks portfolio??