Diversification means different things to different people. Many investors regard any kind of split across stocks and bonds as the proper level of diversification in a single portfolio. Unfortunately, holding these two popular investments is often not enough. To significantly reduce risk and protect against unexpected market swings, investors should use a multi-asset investing strategy.
The Case For Multiple Asset Classes
Empirical evidence suggests in periods of heightened volatility, stock and bond markets often move in tandem with one another. Changing economic conditions that push one market downward can pull the other with it, thereby increasing the correlation between stocks and bonds. For that reason, it's important to pursue diversification on multiple levels, not just through stocks and bonds.
Financial markets are cyclical, and it’s inevitable that a market correction of some kind will eventually occur again. To protect themselves against changes in the value of single assets, investors should look to diversify within distinct asset classes, and consider bringing a healthy mix to their portfolios by pursuing asset classes beyond just stocks and bonds. Holding multiple, non-correlated asset classes in a portfolio can limit downside exposure, while also providing the potential for attractive annual returns.
Traditional thinking holds that because stocks and bonds have different risk profiles, holding them in different proportions in the same portfolio is an adequate way to manage portfolio risk. A 60-40 or 70-30 split between stocks and bonds, for instance, is often thought of as an appropriate, diversified split that can be adjusted based on an investor's appetite for risk.
This notion, however, ignores periods of heightened market volatility that can occur during market corrections, when stocks and bonds tend to be much more correlated with one another. During these times, portfolios limited to stocks and bonds can often experience more significant losses. (For related reading, see: Risk and Diversification.)
Consider the Investor's Risk Capacity
An individual investor’s specific situation is also a crucial factor in designing a suitable portfolio. For example, a younger, high-income earner may be in a position to take on more risk than an individual who is approaching retirement and is more focused on generating income from their investment portfolio to supplement Social Security or their pension.
Some investors have a longer time horizon than others, allowing them more time to recover from any short-term market correction. More conservative investors with less ability to handle volatility may not have that flexibility. Regardless of the investor's situation and unique investment goals, it’s important to understand that investment decisions are not made in a vacuum.
Factor in Market Conditions and Trends When Diversifying
Considering broad market conditions and macroeconomic trends is a crucial step in shaping an asset mix that best suits any individual investor's circumstances. For example, the level and direction of market interest rates is a contributing factor in determining allocation decisions. Economic productivity as measured by gross domestic product (GDP) is another important consideration.
Generally speaking, if prevailing interest rates rise, as they have over the year 2018, bond prices will fall. The Federal Reserve's increase of the benchmark rate to nearly 2% in June 2018 had an apparent negative effect on bond prices. Moreover, this trend of rising interest rates in the U.S. is projected to continue over the next couple of years.
The fact that rising interest rates tend to have a dampening effect on equity markets is not as frequently discussed as its impact on bond prices. Cheap money makes it easier to operate and grow productivity. Conversely, when the cost of capital rises for companies because of increasing market interest rates, it becomes more expensive for companies to finance operations. This can limit productivity growth and impact stock prices. If the Federal Reserve continues to raise interest rates (and indications are that they will), the long bull market investors are currently enjoying will be under some pressure in the long-run.
Non-traditional asset classes, like commercial real estate, private equity and private debt, can often act as a hedge to rising rates. Incorporating these “alternative” asset classes into a portfolio that already includes stocks and bonds allows an investor to lower their overall portfolio correlation. In addition, the portfolio will be in a better position to hedge against rising interest rates. (For related reading, see: Top 5 Alternative Investments to the Stock Market for 2018.)
There is no investment strategy that is risk-free. However, by diversifying across multiple asset classes, investors can reduce the impact any one macroeconomic event or market trend could have on an individual portfolio.
Diversification Protects Your Portfolio From Emotional Investing
The current, nearly 10-year-long bull market, has likely lulled many individual investors into a type of optimistic stupor. It's hard to know how many of them would react to a 50% paper loss in portfolio value when many have not had to think about any sort of decline in recent years.
In a stock market crash, however, a single bad decision – like panic selling – can destroy years of wealth accumulation in an instant. Investors should take a hard look at their individual situations and determine whether they can stomach that sort of turbulence before it happens (not after). It's human nature to get drawn into the momentum of the market. When there's widespread panic, not selling is a lot easier said than done. Emotional investing is a recipe for losing money in good times and in bad.
Ultimately, that may be the strongest argument for not putting all of your investing "eggs" in a single asset basket. If a portfolio is well-diversified across different asset classes, emotional decision-making is less likely to occur during periods of increased market volatility. It is easier to objectively handle a stock market crash if the real estate or private debt portion of your portfolio continues to churn out stable and consistent monthly income. (For more, see: Tony Robbins on Emotional Investing.)
Moreover, if a person is at a phase in their life where they rely on investment income, like many retirees, having too much exposure to the stock market may open their portfolio up to excessive risk in a protracted market downturn.These behavioral quirks in personal finance can be better mitigated by including certain alternative investments in an individual’s portfolio.
Invest in Non-Traditional Assets Wisely to Reduce Risk
Not everyone has the time, or feels inclined, to study each individual investment option available. It can be a lot to keep up with. With that said, speculative investing without acquiring the proper expertise or performing the necessary research to thoroughly vet an idea is akin to gambling.
Alternative investments can often be difficult concepts to analyze. While conducting the appropriate research may seem like a huge task now (especially if your portfolio is currently outperforming), investing in non-traditional asset classes can make a major difference in protecting your portfolio in the event of a downturn, when correlated markets are under pressure.
(For more from this author, see: Why Student Loan Debt Might Be the Next Financial Crisis.)
Disclosure: Securities offered through Kalos Capital, Inc., and investment advisory services offered through Kalos Management, Inc., ("Kalos") both at 11525 Park Woods Circle, Alpharetta, Georgia 30005. Caliber Financial Partners, LLC, is not an affiliate or subsidiary of Kalos. Member FINRA/SIPC.
The opinions in the preceding commentary are as of the date of publication and are subject to change. Information has been obtained from a third party sources we consider reliable, but we do not guarantee the facts cited are accurate or complete. This material is not intended to be relied upon as a forecast or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. We may execute transactions in securities that may not be consistent with the report's conclusions. Investors should consult their financial advisor on the strategy best for them. Past performance is no guarantee of future results. Kalos Capital, Inc. does not provide tax or legal advice. The opinions and views expressed here are for informational purposes only. Please consult with your tax and/or legal advisor for such guidance.