Spotlight on diversification
The economic effects of the pandemic, rising inflationary pressures and the promise of sustained low interest rates suggests a challenging time ahead for investors. How can portfolio diversification help meet your investment goals in such uncertain times?
- Well-diversified portfolios can help investors keep portfolio volatility within acceptable limits as the risk of uncertainties sparked by low interest rates, mounting inflationary pressures and COVID-19 uncertainties hangs over markets
- Safe-haven assets like government bonds, gold, the US dollar and Japanese yen have averaged positive performance in the quarters when global equities lost more than 10% since 2001
- Portfolio diversification may need to be reviewed if changing macroeconomic conditions risk reducing the expected protective power of combining different asset classes
- An investor’s reference currency can influence portfolio returns in falling markets and help direct how assets are invested
- Portfolio diversification may need to be reviewed if changing macroeconomic conditions risk reducing the expected protective power of combining different asset classes.
Volatile financial markets are a fact of life for investors in equities and other risk assets. Spreading capital across different asset classes can help keep the swings in portfolio valuations from such volatility to acceptable levels. In addition, it may be worth considering different extreme-risk scenarios, such as a viral pandemic, and evaluating their potential impact on portfolio performance.
The investor should lie at the heart of asset allocation and portfolio construction decisions. Clearly defining investment needs and goals, such as investment horizons and liquidity requirements, can help. In addition, a firm understanding of their risk tolerance and risk capacity helps.
Building portfolios thought to reflect an investor’s needs, risk attitude and investment style requires knowledge of the above factors. A structured and diligent investment process can help to meet desired long-term goals, while navigating risks and opportunities. As such, diversification is generally considered at the first stage of any investment process.
The place for safe-haven assets
Equities play a key role in most portfolios, except for the most risk averse clients. Historically, the asset class has provided a 6-7% premium on top of the return offered by risk-free assets like US Treasuries. However, this excess return usually comes at the cost of higher volatility and large losses during market sell-offs (for instance, many equity markets had a 40-50% drawdown in the global financial crisis of 2008-2009).
To counteract the risks associated with equities in portfolios, so-called “safe-haven assets” (or assets expected to provide protection when equities perform poorly) might be considered.
Safe-haven assets like government bonds, gold, the US dollar and Japanese yen have averaged positive performance since 2001 in the quarters when global equities lost more than 10%. That said, changing macroeconomic conditions may affect correlations between different asset classes, possibly reducing their protective power. Moreover, safe-haven assets usually provide low income and can hit performance over longer investment horizons. As such, there is a trade-off between portfolio return and risk.
Combining equities and bonds
Government bonds, along with equities, can be a core part of portfolios. The bonds can offer stable and secure income. As such, they often act as a counterweight to equities, especially during market downturns.
However, the correlation of government bonds with equities can change. Indeed, at a time of rising inflationary pressures, it is worth noting that historically, the performance of the two asset classes has usually been more correlated as inflation rises.
Low-interest rates also leave limited scope for capital gains on government bond investments. Indeed, these macroeconomic factors have led many to question the diversification potential of government debt.
The effect of the economic backdrop
The dispersion of equity-bond correlations in the eurozone, Switzerland, UK and US has increased significantly since 2003. On average, the equity-bond correlations are negative.
That said, the correlation level is close to zero in Switzerland (where zero implies no correlation between the two asset classes and +1 or -1 implies a perfect positive or negative relationship, respectively) and around 0.1 in the eurozone. Meanwhile, correlations are negative in the US (-0.4) and the UK (-0.2). This suggests that the macroeconomic backdrop is an important driver of the interplay between equities and bonds.
The currency factor
The investor’s reference currency can influence portfolio returns in down markets, according to our research. In fact, an analysis of safe-haven currencies, from safe-haven ones like US dollars to commodities-driven ones like the Australian dollar and based on their average and tail correlation with global equities, indicates that they are an integral part of the diversification mosaic.
Keep diversifying for success
Diversification lies at the heart of our investment philosophy. A thorough analysis of many factors and their interconnectedness can help find the optimal asset for each investor. Establishing a diversified portfolio that can serve you well in different market regimes should be based on understanding desired investment goals and the relevant risk appetite.
Focusing on the potential portfolio performance over the long term, while paying attention to the short term and the possible impact of volatility on investors’ behaviour, is probably the key to successful investing.
Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.
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