The standard deviation of returns for fixed-income assets, on the
other hand, does not fall as fast as the random walk theory predicts. This
is a manifestation of mean aversion of bond returns. Mean aversion
means that once an asset’s return deviates from its long-run average,
there is an increased chance that it will deviate further, rather than re-
turn to more normal levels. Mean aversion of bond returns is especially
characteristic of hyperinflations, such as those that impacted Japanese
and German bonds, but it is also present in the more moderate inflations
that have hit the United States and the United Kingdom. Once inflation
begins to accelerate, the inflationary process becomes cumulative and
bondholders have virtually no chance of making up losses to their pur-
chasing power. In contrast, stockholders who hold claims on real assets
rarely suffer a permanent loss due to inflation.
VARYING CORRELATION BETWEEN STOCK AND BOND RETURNS
Even though the returns on bonds fall short of that on stocks, bonds may
still serve to diversify a portfolio and lower overall risk. This will be true
if bond and stock returns are negatively correlated, which means that bond
yields and stock prices move in opposite directions. The diversifying
strength of an asset is measured by the correlation coefficient. The correla-
tion coefficient, which theoretically ranges between –1 and +1, measures the
correlation between an asset’s return and the return of the rest of the port-
folio. The lower the correlation coefficient, the better the asset serves as a
portfolio diversifier. Assets with negative correlations are particularly
good diversifiers. As the correlation coefficient between the asset and
portfolio returns increases, the diversifying quality of the asset declines.
The correlation coefficient between annualstock and bond returns
for six subperiods between 1926 and 2006 is shown in Figure 2-4. From
1926 through 1965 the correlation was only slightly positive, indicating
that bonds were fairly good diversifiers for stocks. From 1966 through
1989 the correlation coefficient jumped to +0.34, and from 1990 through
1997 the correlation increased further to +0.55. This means that the di-
versifying quality of bonds diminished markedly from 1926 to 1997.
There are good reasons why the correlation became more positive
during this period. Under the gold-based monetary standard of the
1920s and early 1930s, bad economic times were associated with falling
commodity prices; when the real economy was sinking, stocks declined
and the real value of government bonds rose.
Under a paper money standard, bad economic times are more
likely to be associated with inflation, not deflation, as the government at-
30 PART 1 The Verdict of History