When to Diversify Differently

Abstract

Government bonds are supposed to diversify equities, and they typically do. Assets do not have to be negatively correlated to diversify each other, although a negative correlation can help. The authors provide an analysis of what can cause the sign of the correlation coefficient between government bond returns and stock returns to flip. This can help inform whether and when to seek out diversifiers other than government bonds. Using a variety of statistical tests, the authors show that the correlation has gone through periods of structural change since the 1980s that tend to coincide with major crises, such as the Asian Financial Crisis and the Global Financial Crisis. They also show that the stock–bond correlation has tended to decline as the link between growth and inflation has weakened and as the level and volatility of inflation has declined.