Stocks and bonds trade in two separate asset classes: the former are equities, the latter fixed income. These two investment categories tend to have a low correlation, meaning the financial securities that trade in each group respond differently to certain factors. Stocks are largely driven by corporate profits, while bonds are most sensitive to economic conditions.
When stocks and bonds operate with a low correlation, investors respond to the events that most directly affect each asset class. For bonds, this includes changes in economic conditions that are likely to alter inflation and subsequently trigger changes in short-term interest rates. Equity investors are sensitive to increases or decreases in corporate profitability as well as perceived valuation of stocks. An undervalued equity, for instance, could present a buying opportunity.
A bond's primary components are its yield and price, and the two move inversely. As bond prices fall, the yield, or the interest that a fixed income instrument pays, rises. Bond investors generally flee when signs of inflation surface because this economic condition causes deterioration in the worth of the income stream that debt securities generate. Although rising inflation can also hurt the stock market, equity investors place major emphasis on the environment for corporate profits. The market value, or price of a stock, often reflects whether a company is able to satisfy income expectations.
Although bonds and stocks have a tendency to trade with a low correlation, this is not always the case. Investors might be inclined to treat each category similarly when some high emotion, such as fear, dominates the markets. Throughout the economic recession that began in 2007, economic fears permeated both fixed income and equity investors. As a result, both asset classes traded similarly for three years before that trend finally began to reverse in the fourth quarter of 2010, according to Bloomberg Business Week.
The fact that stocks and bonds often have a low correlation can be used to an investor's advantage. By incorporating both asset classes into a portfolio, an investor achieves some level of diversification. If one category falters, the other inversely performing asset class may compensate for that weakness. This can be especially true with investments having a low correlation in a portfolio. If investors are fleeing bonds in favor of stocks, a well-diversified fund will reflect both sides of this trend.
- Hemera Technologies/Photos.com/Getty Images