Diversification means different things to different people. Many investors regard any kind of split across stocks and bonds as diverse enough to feel protected against unexpected market swings. Unfortunately, holding these two popular asset classes is often not enough to significantly reduce risk in a single portfolio.
Empirical evidence suggests that 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.
First, investors should look to diversify within distinct asset classes in order to protect themselves against fluctuations in the value of individual investments. Secondly, they should consider further diversifying their portfolios by incorporating asset classes beyond just stocks and bonds. Examples of such asset classes may include investments in commercial real estate, private equity, oil & gas, precious metals and private credit.
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Financial markets are cyclical, and it’s inevitable that a market correction of some kind will eventually occur again. Thus, holding multiple, non-correlated asset classes in a portfolio can limit downside exposure, while also providing the potential for attractive annual returns.
The case for multiple asset classes
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. In periods of heightened market volatility, investor portfolios limited to stock and bond allocations can often experience more significant losses than they would otherwise anticipate.
An individual investor’s specific situation is also a fundamental determinant 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 approaching retirement, who may be more focused on generating income from their investment portfolio to supplement Social Security or a pension.
Some investors have a longer time horizon than others, thereby 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.
Of course, it’s important to understand that investment decisions are not made in a vacuum. Considering broader 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 GDP is another important consideration.
When cost of capital rises due to increasing market interest rates, it becomes more expensive for companies to finance operations. This can limit productivity growth and impact stock prices. As interest rates fall, borrowing money becomes easier and companies have more accessibility to finance new ventures. While the U.S. economy is currently in a period of stability, the future direction of interest rates is dependent on many factors and events.
Moreover, as we move into an election year and the U.S. and China continue to negotiate a trade deal, the equity markets may experience more volatility in 2020.
Crisis management
The current bull market has likely lulled many individual investors into a level of irrational exuberance. With few, if any, protracted corrections in the stock market over the last decade, it’s hard to predict how current investors might react to a significant decline in their portfolio values.
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 is 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 disaster in good times and in bad.
Ultimately, that may be the most poignant argument in favor of keeping all the eggs out of a single asset basket. If a portfolio is well-diversified across multiple classes of assets, decision-making based on emotion is less likely to result in periods of increased market volatility.
It is objectively easier to handle a stock market crash when the real estate or private debt portion of your portfolio continues to churn out stable and consistent monthly income. 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.
Enlisting help from a pro
Not everyone has the time nor the inclination 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 a sophisticated arena to analyze. Those investors who are uncomfortable conducting the proper due diligence needed to better understand these investments are much better off working with a Certified Financial Planner (CFP®), who may be better equipped to research such investments and has the experience necessary to guide individuals through their investment decisions. The advice of a professional experienced with alternative investments can be invaluable in assisting investors with making informed decisions.
A trusted financial adviser will evaluate the risk tolerance of a given individual before making a recommendation about their ideal portfolio mix. With that said, holding nontraditional asset classes can make a major difference when correlated markets are under pressure.
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 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.
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