The yield on the 10-year US Treasury bonds had dropped to around 3.3% in the spring, but it subsequently increased significantly, approaching 4.9%. Investing in bonds, determining the right timing, and deciding whether or not to hedge against currency risk when investing in US bonds have become challenging questions.
Amidst this, as bond yields have risen significantly, companies are facing increased borrowing costs, leading to a decline in stock prices. In other words, we are witnessing a situation where both bond and stock markets are falling simultaneously, and this simultaneous decline of bonds and stocks has become a major topic of discussion among institutional investors.
It is possible that individual investors may not be paying as much attention to this phenomenon as institutional investors. The difference between individual and institutional investors often becomes evident in how they approach asset management. Individual investors tend to focus on individual investments, whereas institutional investors often take a more holistic portfolio approach. Building a diversified portfolio involves mathematical considerations, which can make it more challenging for individual investors.
However, many experienced individual investors do understand portfolio management. Therefore, it would be beneficial if the concept of considering one's entire portfolio becomes more prevalent among individual investors. In this context, I'd like to discuss how to approach situations where both stocks and bonds are declining.
In the United States, there are many funds that construct portfolios with a 60% allocation to bonds and a 40% allocation to stocks, or even a 50-50 allocation. While there isn't always a clear rationale for these specific ratios, many funds choose them based on investors' risk tolerance. For example, Japan's Government Pension Investment Fund (GPIF), which manages the national pension, has set a target allocation of 50% bonds and 50% equities as a combination to achieve its return objectives.
The rationale behind these 60-40 or 50-50 allocations is to take advantage of the fact that stocks and bonds often move in opposite directions. Traditionally, bonds tend to rise when economic conditions deteriorate, leading to lower interest rates, while stocks tend to perform well when the economy is strong. This negative correlation, where one asset's gains offset the other's losses, is the foundation of effective diversification.
However, if both stocks and bonds start moving in the same direction, the benefits of diversification can diminish. Since August, there has been an accelerated increase in US bond yields, coinciding with a declining stock market. Bonds are typically bought when interest rates fall, which can stimulate stock markets as well. This pattern of behavior has become more frequent recently.
If this trend continues where stocks and bonds move together, it suggests that tighter monetary policies may persist for some time, and an environment with sustained high energy prices could also contribute to stocks and bonds moving in the same direction.
While the significant price volatility observed between August and September may have prompted some investors to adjust their portfolios, not everyone will make the same moves. For instance, as mentioned earlier, GPIF has a long-term investment horizon and does not frequently change its 50-50 allocation, as it considers short-term disruptions in asset class correlations as temporary. The fund follows a consistent strategy, as trying to time these shifts and predict when things will return to normal is challenging and often unsuccessful.
In contrast, investors with shorter investment horizons and lower risk tolerance may need to consider temporary adjustments in response to the current volatility in both stocks and bonds.
In conclusion, with rising bond yields and declining stock prices, portfolio construction has become more challenging. It's advisable for individual investors to consider a holistic portfolio approach when making investment decisions, as this can lead to more stable asset management. In this discussion, we've explored how to approach situations where both stocks and bonds are declining simultaneously.