Question

Jarvis expects a pickup in US inflation to result in rising rates, causing a steep correction in the stock market. He decides to shift to a “60/40 allocation” with 60% in stocks and 40% in treasury securities, mainly the 10 and 30 US treasury bonds. He reasons that this allocation helped protect investors from the steep market correction in 2008. What is the flaw in his reasoning and risks to his strategy?

Answer 1

The 10 and 30 year US treasury bond price are likely to decline with rising inflation and interest rates. Higher the duration, the steep the fall in bond price with increase in interest rates. Hence, moving from 100% stocks to 60/40 allocation will unlikely to protect from the correction because the 40% allocation to long duration bonds are also likely to decline. Hence, his reasoning is flawed. Ideally, he should invest in short-term treasury securities which are likely not to decline much and benefit in rising interest rate environment.