Sliced pumpkin pie above view on blue background. People grabbing slices of cake stock photo

Many investors are turning to alternative asset classes like gold and real estate to diversify their portfolios. But alternative diversifiers to investment-grade bonds have lower returns over the long term, higher correlations and more volatility, finds a report from Chicago-based Morningstar Inc.

Adding bonds to an equities-only portfolio used to be a “no brainer,” said Amy Arnott, portfolio strategist with Morningstar and the report’s author. But the traditional 60/40 mix was challenged when both stocks and bonds fell in 2022.

Nonetheless, a 60/40 portfolio composed of U.S. stocks and high-quality bonds had better risk-adjusted returns than an all-stock benchmark in more than 87% of the rolling three-year periods from 1976 to 2023, according to the report. In comparison, a diversified portfolio only outperformed the all-stock benchmark 68% of the time.

“People like to beat up on the 60/40 portfolio, and it was definitely an easy target when it had pretty painful losses in 2022. But the flip side is it does have a pretty solid record of improving risk-adjusted returns over time,” Arnott said.

Common diversifiers like REITs and high-yield bonds have a higher correlation to U.S. equities than investors might expect, decreasing their diversification benefits, the report said. The correlation coefficient of a diversified portfolio against the Morningstar U.S. Market Index rose from 0.87 in the three years ended Dec. 31, 2004, to 0.94 for the three years ended Dec. 31, 2023.

Equities in other developed markets are also highly correlated with U.S. equities, according to the report. If investors diversify into international stocks, they should have exposure to both developed and emerging markets, Arnott said.

And while gold has a low correlation to stocks and could help cushion a portfolio against losses in a down market, it hasn’t performed as well as equities over the past several decades, she said.

In recent years, cash was a better diversifier than Treasuries as interest rates rose. Unlike bonds, cash isn’t sensitive to interest rates; it’s also a low-volatility and low-correlation option, Arnott said.

Investors looking to retire or who have recently retired should have a couple of years’ worth of cash to cushion against market volatility, she said. That will “help minimize the risk that you’ll have to draw down assets when your portfolio is down.”