Avoid putting all your eggs in one basket is Investing 101. By investing in a variety of asset classes, such as stocks, bonds, and commodities, investors hope to earn a reasonable return over time and avoid sharp swings in the value of their portfolios. A common rule of thumb has been that equities go up when the economic outlook brightens while bonds do better when the clouds darken. Their low correlation to one another is why they tend to be paired up in portfolios.
After the 2007-2008 financial crisis, many central banks pursued policies that helped drive up asset values across markets, from equities, bonds, and real estate to alternative investments like art and exotic cars. Because these markets became more positively correlated with each other, many investment portfolios rose with the rising tide, even portfolios that were not well diversified.
But over the past few months, there has been a sharp decline in the correlation between different asset classes (see chart), taking the measure back to where it was before the 2007-2008 financial crisis. Rather than being closely linked, returns in different markets have lately become more divergent. If sustained, this suggests investors will once again need to be acutely focused on making sure their portfolios are properly diversified.
A recent article in The Economist explains what may be behind this renewed urgency to focus on diversification:
“Now that central banks are no longer quite so supportive, it may be time for markets to go their separate ways. The actions of central banks swamped the economic fundamentals; those factors can now reassert themselves. In the first few weeks after Donald Trump’s victory in the presidential election, the value of global shares rose by $3 trillion and that of bonds fell by the same amount, according to Torsten Slok of Deutsche Bank. The Dow Jones Industrial Average passed 20,000 for the first time on January 25th. Emerging markets have underperformed American shares since Mr. Trump’s victory.
The rationale behind such differences is that tax cuts in America will improve economic growth (good for equities) but widen the budget deficit and push up inflation (bad for bonds). Mr. Trump’s threats of tariffs and border taxes will be good for domestically focused American companies, less so for businesses operating in developing countries.”
How much diversification should an investor have in a portfolio? There is no single answer, because it depends on what they want to do with the money and their time horizon. With this in mind, investors should consider diversifying each of their asset “buckets.” For example, they could diversify their stock holdings by owning different amounts of large and small capitalization stocks, value and growth stocks, or mutual funds distributed across domestic and international stocks. For their “bond bucket”, investors could consider a variety of maturities and issuers (Treasuries, municipalities, and corporates), depending on market conditions and their own tax situation.
DISCLAIMER: This information is not intended to provide legal or accounting advice, or to address specific situations. Please consult with your legal or tax advisor to supplement and verify what you learn here. This is presented for informational or educational purposes only and does not constitute a recommendation to buy/sell any security investment or other product, nor is this an offer or a solicitation of an offer to buy/sell any security investment or other product. Any opinion or estimate constitutes that of the writer only, and is subject to change without notice. The above may contain information obtained from sources believed to be reliable. No guarantees are made about the accuracy or completeness of information provided. Past performance is no guarantee of future results.