The hidden risk factor investors may be missing in stocks, bonds, and options

• Investors may need to take on more risk due to muted returns.
• Traditional 60/40 stock-bond diversification faces challenges due to correlation.
• Deploying rate-sensitive securities for their upside may increase risk exposure.

Investors may soon be forced to take on more risk and rethink their diversification strategies due to macroeconomic uncertainties.

The Federal Reserve's rate cuts mean returns on cash will decline. Bond yields may fluctuate due to concerns over inflation and the deficit. And, the broad market could see muted gains, per an October note from Goldman Sachs that expects the S&P 500 to return a mere 3% annually for the next 10 years. This leaves little room for safe havens.

In general, diversification has been a challenge for investors over the last couple of years as stocks and bonds moved in tandem to a degree we haven't seen in quite some time, says Jon Adams, CIO at Calamos Wealth Management. And that presents challenges for those who follow the traditional balance of 60% stocks to 40% bonds as a diversifier, he added.

"Momentum has really been driving equities higher across the board, especially with respect to large-cap growth names," Adams said. "So, concentration has clearly been a concern for investors over the last few years."

On the bond side, the biggest threat will be the implication of policy changes and how it will impact the Treasury market, says Jimmy Chang, the CIO of the Rockefeller Global Family Office. The 10-year yield spiked after President-elect Donald Trump won the election.

Bond investors quickly discounted the risk of rising tariffs and tighter immigration policies, both of which could aggravate inflation and push yields even higher, Chang said, adding that long-duration bonds could be facing their own set of headwinds.

The new approach to 60/40

That said, the risk-reward tradeoff — a measurement of potential profit versus loss— may become the real measure of diversification.

But it won't be easy since it's one of the longest-standing ratios academics studying financial markets have grappled with: must risk increase with returns?

It's not an obvious answer and hinges on a few latent factors, according to a recent study by Wharton's finance department. The study found that stocks, bonds, and options strategies could have more correlated risk than is evident on the surface. And that link could strengthen as you deploy certain variables across sectors to gain more upside.

The latest version of the study, published June 2024, analyzed data from June 2004 to December 2021 with trading strategies built on signals such as momentum, beta, price behavior, and accounting variables using 35 characteristics for stocks, 26 for corporate bonds, and 19 for options to extract the factors that cause them to behave the same way.

While many signals were difficult to detect manually, it found that one key culprit that increased systemic risk amid macroeconomic uncertainty across all three securities was bond duration, likely due to interest-rate sensitivity. More simply, if a portfolio has a high degree of exposure to long-duration corporate bonds, an investor may want to rethink their positions in interest rate-sensitive sectors in equities or options, and vice versa.

Overall, seeking upside in corporate bonds offered little in terms of excess returns without increasing correlated risk that could be found across all three securities, noted Nikolai Roussanov, a professor of finance at the Wharton School.

It makes sense, says David Kelly, chief global strategist at JP Morgan Asset Management, who noted that the correlation would be higher between certain sectors within equities like growth stocks, which correlate more to long-duration bonds than value stocks because the former relies on future earnings and long-term interest rate changes.

"When you've got high long-term interest rates, the present value of all those far-flung cash flows, it gets just eaten up," Kelly said. "So value stocks are about the here-and-now, growth stocks are about the hereafter."

There are two ways out of this, Kelly noted. First, avoid putting all your eggs in the US basket of stocks and consider international equities. Investors tend to be underweight in the latter, he said, but there's no harm in adding them. He also suggests alternatives that could mimic fixed-income returns but aren't bonds. Examples include funds that invest in real estate, infrastructure, and transportation.

Adams seconds the advice on alternatives, adding that public and private infrastructure investments, particularly those exposed to data center and power demand, have been part of their risk mitigation strategy, acting as a partial hedge against a higher rate or inflationary environment.