April 27, 2022
It Might Not Be Enough to Diversify at the Asset Class Level
Traditional investing, frequently coined a “buy and hold” investment strategy, incorporates a mix of assets that create a portfolio of investments. This portfolio of assets generates an expected return given an investors’ risk profile. We refer to this type of investing as Strategic Asset Allocation (SAA).
At the core of SAA, is the mathematical framework introduced in Modern Portfolio Theory (MPT). According to MPT, the goal is to compile a mix of assets that will produce an optimal portfolio based on expected risk and return. In a nutshell, an “optimal” portfolio can be created with the appropriate asset mix and this portfolio will fall on the “efficient frontier”.
MPT can be found in most financial text related to asset allocation; however, it does operate with a number of limitations. The use of historical data to predict how a portfolio may perform in the future is problematic. Financial markets often do not behave this way in reality. Historical estimates of risk and return do not consider a changing and dynamic investment landscape in the future.
Financial markets can exhibit periods of weakness for a number of reasons. In near term, markets become stressed because of structural problems that arise from constraints on liquidity. Economic conditions may weigh on assets if concerns exist over the potential for a recession loom based on changing unknown business cycles.
What we have seen in practice is that markets will become stressed. If they become severely stressed, the correlation between these historically diversified asset classes can converge toward one. In layman terms, all these asset classes will move strongly in the same direction. The most recent example is the COVID-19 lockdown-induced recession. The speed and deterioration of once diversified asset classes was nothing short of breathtaking. Not even an investment in Treasury bonds was safe from investors’ need for liquidity during the month of March 2020.
Periods of market stress may create unwelcomed volatility that the investor is not expecting. So how do we best prepare these types of market risk? Considering each investors’ unique perspective with regards to investments, it may make sense for the investor to discuss with a relationship manager to understand how introducing diversified investment strategies could produce a more robust return and risk profile. The potential benefits from adding tactical and dynamic investment approaches may be an appropriate fit for the investor. Each investment strategy has its merits; however, each will provide different risk and return characteristics throughout a changing investment cycle.
To conclude, it is important to consider positives and negatives of each investment strategy and how they interact on a stand-alone or blended approach. Has your financial advisor discussed different investment strategies for your portfolio? If the answer to this question is no, it is important that the investor understands that a discussion about different investment strategies with one of our relationship managers could be useful. The discussion will certainly help the investor to understand how each investment strategy works in this different and quickly evolving investment landscape. Schedule your financial plan review and investment strategy discussion today.