So what’s the bottom line for investors? For much of the last fifty years, an investor in money markets and other short-term instruments could earn a reasonable after-inflation return without taking on much risk. Today, of course, this is no longer the case.
But as bonds are still a strategic asset class providing income, stability and diversification, abandoning them isn’t the answer (even if I do like stocks more than bonds).
Market Realist – The asset correlation matrix proves that Treasuries are great diversifiers.
The asset correlation matrix above shows the correlation coefficient between Treasuries, developed markets, and emerging market stocks. Treasuries are tracked by the iShares Barclays 7-10 Year Treasury Bond Fund (IEF) and the S&P 500 (SPY). Developed markets are tracked by the iShares MSCI EAFE Index Fund (EFA). Emerging market stocks are tracked by the iShares MSCI Emerging Markets Fund (EEM). It tracks monthly returns for ten years.
From the portfolio diversification point of view, the correlation between two asset classes should be close to zero. A correlation coefficient of one means the two assets move together, proportionately. A correlation of one means the two asset classes move in opposite directions.
There’s a high correlation of 0.81 between emerging market stocks and the S&P 500. This shows that emerging markets aren’t insulated from events that happen in the rest of the world (QWLD).
In the graph, the correlation between Treasuries and all other asset classes is negative. In contrast, all other assets are highly correlated with each other.
This means that Treasuries add great diversification benefits to a portfolio that only contains equities. This is shown in the asset correlation matrix.
The last part of this series explains where you can find yield today.