Did 2022 Kill the “60/40” Portfolio?
Constructing an investment portfolio that can withstand financial downturns requires a deep understanding of the relationships between different assets. One key factor is correlation, which measures how assets move in relation to each other and informs strategies such as portfolio diversification.
The Role of Correlation Coefficient is Less Than Perfect
The correlation coefficient quantifies the degree to which two assets move in relation to each other. A correlation coefficient of +1 indicates perfect tandem movement, -1 represents exact opposite directions, and 0 implies no relation. For diversification to effectively reduce portfolio risk, assets need to be less than perfectly correlated. If all assets in a portfolio were perfectly correlated, there would be no risk reduction benefit from diversification.
The Disrupted "60/40" Portfolio
One of the mainstays for investors, the historically low correlation between public equities and bonds, has been crucial in the "60/40" portfolio. However, this low correlation relationship was disrupted in March 2022 when the Federal Reserve began raising interest rates aggressively and to the highest level in 50 years, in an effort to combat inflation. Bonds and equities declined in tandem and failed to act as a counterweight to each other, resulting in the “60/40” portfolio having one of its worst years on record.
This is a reason for diversification. If your entire investment portfolio consisted solely of bonds and public equities in 2022, it undoubtedly suffered from the tandem decline. Fortunately, the S&P 500 has rebounded, yielding a close to 15% return year to date, and real yields are at their highest in decades.
But public equities and bonds are not the only 2 asset classes that belong in a well-diversified portfolio. There are other asset classes that have a low correlation to stocks and bonds, and there is a reason why UHNWs and institutional investors include these in their portfolios and even have substantial allocations to some of them.
So, where do you start?
Here are some Investment Options for Portfolio Diversification:
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- Private Equity: Investing directly in private companies or through funds can offer returns that are not tied to the broader stock market's ebb and flow. Private companies are not subject to the market sentiment swings that public companies face. Their valuation is managed over a longer time period (public equities are daily) and is based more on fundamental analyses thus removing market sentiment which can be volatile and influenced by short-term factors.
- Real Estate: Direct real estate investments, like properties and indirect investments like Real Estate Investment Trusts ( REITs), provide cash flow and value appreciation distinct from traditional markets.
- Hedge Funds: Utilise various strategies for positive returns regardless of market direction, often striving to be market-neutral means their returns are uncorrelated with broader market returns.
- Commodities: Gold, oil, and agricultural products are independent from stocks and bonds, for example, Gold is frequently seen as a hedge against inflation and currency fluctuations.
- Cash/ Cash Equivalents: Low-risk investments like Treasury bills, money market funds and short-term commercial paper, offer capital preservation during volatile market conditions when riskier assets may be losing value.
While a UHNW portfolio can teach us a lot, your portfolio should reflect your time horizon, risk tolerance and appetite, need for liquidity and income. But diversifying beyond just equities and bonds is a crucial principle for all investors. As the landscape of financial markets continues to evolve, and as new asset classes and investment vehicles emerge, the importance of low correlation becomes even more pronounced.
A well-diversified portfolio isn't just about mitigating risks; it's about optimising for potential returns. By adding assets with low correlations, you not only cushion your investments from synchronised declines but also position yourself to capitalise on a broader range of opportunities. Remember, the ultimate goal isn't to predict the markets perfectly (because that’s impossible!), but to build a resilient portfolio that can navigate the unpredictable tides of the financial world. So, as you reflect on your investment strategy, consider the merits of diversification and the impact low correlation can have on achieving your long-term financial goals.
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