Diversifying portfolios for a post-pandemic world
Investing is likely to be challenging in a world of low rates, mounting inflationary pressures, rebounding growth and elevated equity valuations. How might well-diversified portfolios help investors to prosper during such uncertainties?
- Well-diversified portfolios can help investors when investing at a time of low interest rates, rising inflation risks and the uncertainties sparked by the COVID-19 pandemic
- So-called safe-haven assets, like cash and government bonds, may help to dampen portfolio volatility during sharp financial market sell-offs
- Equities can play a valuable role in diversified portfolios and have historically provided a 6-7% premium over returns offered by risk-free assets, though with additional volatility
- An investor’s reference currency can affect portfolio returns in down markets and help direct how assets are invested
- Focusing on the potential long-term performance of portfolios, while keeping an eye on the short term and the potential impact of volatility on investors’ behaviour, is probably the key to successful investing.
Crafting a well-diversified portfolio is a key tenet for investment success and growing wealth. Spreading capital across different asset classes can help keep portfolio volatility under control. However, this is only half of the story. It may be worth considering different scenarios and evaluating their impact on portfolio performance in attempting to limit the potential impact of extreme risk events.
Setting your investment goals
Before delving into subtleties of financial markets, clearly defining investment needs and goals can help. For example, investors should specify their reference currency, investment horizon, liquidity requirements, need for steady cash flow, lifestyle requirements and aspirational goals. Ascertaining an investor’s risk tolerance and risk capacity helps too.
Building optimal portfolios that reflects 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.
Equities are an essential part of most portfolios, except for the most risk averse clients. Historically, the asset class has provided a 6-7% premium over returns offered by risk-free assets. However, this excess return usually comes at the cost of higher volatility and large losses during market meltdowns (for instance, many equity markets suffered a drawdown of 40-50% within a short period of time in the global financial crisis of 2008-2009).
To mitigate the portfolio risks associated with equity investments, so-called “safe-haven assets” (or assets expected to provide protection when equities perform poorly) might be considered. Cash, government bonds, gold, certain currencies and hedge funds are among assets that typically help in down markets.
Safe-haven assets have averaged a positive performance in the quarters when global equities lost more than 10% since 2001.
However, safe-haven assets can disappoint. Changing macroeconomic conditions may affect correlations, possibly reducing their protective power. Moreover, the 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.
Focusing on the core
Like equities, government bonds often form a core part of portfolios. Treasuries can offer stable and secure income. As such, they are frequently negatively correlated with equities, especially during market downturns.
However, the correlation of government bonds with equities can change. Historically, the two asset classes have usually become more correlated as inflation rises. The low-interest rate environment leaves limited scope for capital gains on government bond investments at the moment. Indeed, these macroeconomic factors has led many to question the diversification potential of Treasuries.
The dispersion of equity-bond correlations in the US, UK, Switzerland and eurozone has increased significantly since 2003. Although equity-bond correlations are negative on average, 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.
Our research shows that an investor’s reference currency can affect portfolio returns in down markets. In fact, a spectrum of currencies can be drawn, based on their average and tail correlation with global equities, ranging from the safe-haven currencies (such as the US dollar and yen) to their cyclical, commodities-driven peers (such as the Canadian and Australian dollars).
This analysis indicates that currencies play an important role in asset allocation and are an integral part of the diversification mosaic.
Diversification is key
Diversification lies at the crux of our investment philosophy. Finding an optimal asset mix involves a thorough analysis of several factors and their interconnectedness. Building a diversified portfolio that can serve you well in various market regimes is predicated on understanding the investment goals and risk appetite.
Focusing on the potential long-term performance of portfolios, while keeping an eye on the short term and the potential 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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