You Should Not Trust Modern Portfolio Asset Allocation in a Rising Rate Environment
If you ask people what the most important aspect of a successful investment portfolio is, the majority of them would tell you diversity. We have it drilled into our heads since the moment we begin learning about investing. However, while this may be the basis of Modern Portfolio Theory, the fact that we’re seeing rising rates that will turn the bonds/stocks correlation positive suggests this theory is on its last legs.
The Basic Premise Behind Modern Portfolio Theory
Modern Portfolio Theory is grounded in the idea that asset classes have no correlation. Therefore, risk can be avoided or, at least, mitigated by investing in a diversified portfolio across asset classes.
However, if the correlations of the different assets classes become unpredictable, the mitigating factors would disappear.
This type of theory is nearly 60 years old, which is why so many have begun questioning whether or not it’s still a practical perspective in today’s market. There are actually a number of ways to intelligently scrutinize this type of thinking, not the least of which is that investors aren’t necessarily rational, nor do they all have the same access to data at the same exact time.
The Stock-Bond Correlation
Many experts have begun advocating a forward-facing view for investors that is driven by macroeconomics, instead of constantly looking to the past for information on how to act in the present.
This has become especially prescient now because of the rising rate environment we find ourselves in.
In a rising rate environment, it’s possible for the correlation that exists between stocks and bonds to turn positive. A strategy that is constantly looking backward would not be able to incorporate a rise in interest rates caused by this type of stock/bond correlation and what that could mean for investors.
Important Words from PIMCO
Sebastian Page, executive vice president and global head of client analytics at PIMCO, states that macroeconomic factors should be considered by investors in their asset allocation decision-making process. In the current financial environment, it is possible that stock/bond correlation could have a significant impact on asset allocation.
Asset class returns and volatilities over the past 20 years reflect that there is a decline in interest rates. Looking forward at given yields and P/E ratios, returns will be different and interest rates will increases meaning a different asset allocation. In a rising rate environment, the correlation can turn positive.
Additionally, research by Pimco shows that from 1927 to 2012, the correlation between the S&P500 and long-term treasures has changed sign 29 times ranging from -93 percent to +86 percent.
Page goes on to conclude that there are four key factors that exist on a macroeconomic level and can affect the stock/bond correlation. They are inflation, real interest rates, growth and unemployment.
Are we seeing the last days of Modern Portfolio Theory? It would appear so, which means you need to act quickly to adjust accordingly.