Diversification has long been considered a crucial component of successful investing and trading, helping to reduce risk by spreading your trades and investments across a variety of assets, asset classes, countries, and currencies.
However, in today’s world, achieving diversification has become more challenging.
Inflation, geopolitical risks, and the need for inflation protection all present significant obstacles for traders/investors look to build diversified portfolios.
In this article, we look at these challenges in more detail, and discuss strategies that traders/investors can use in these conditions, while still achieving their goals.
Key Takeaways – Diversification Challenges
- Diversification is becoming more challenging due to factors such as inflation, geopolitical risks, and the increased flight into private assets. Traditional asset classes such as stocks and bonds may not provide adequate diversification.
- China poses a significant risk due to rising tensions with other countries, regulatory environment, and lack of transparency. Investors must carefully weigh the risks and potential rewards of investing in China.
- Illiquid assets such as private equity, real estate, and infrastructure can provide longer-term returns that may be less impacted by short-term market fluctuations but also come with risks. Inflation protection is important to consider when constructing portfolios, and inflation-linked bonds and commodities can provide protection against inflation.
Stocks and bonds are not inherently diversifying
Stocks and bonds are two of the most commonly held asset classes in investment portfolios, but they are not inherently diversifying.
While it has been true that equities and fixed income instruments have held a negative correlation in previous environments, that has been less true today.
Before, growth was the dominant driver because inflation was relatively steady.
Now there’s a lot more variability in inflation and growth has been less volatile.
Bonds and stocks diversify fairly well with respect to changes in growth (equities do best when growth rises faster than discounted while bonds do best during periods where growth lags consensus).
As a result, holding only stocks and bonds in a portfolio may not provide adequate diversification, as they may move in the same direction during market downturns when inflation in the main driver of financial asset returns. In turn, this can amplify portfolio risk.
Inflation can erode the real value of fixed-income securities like bonds, reducing their purchasing power over time.
Similarly, high inflation can lead to a decrease in consumer spending and a decline in corporate profits, which can negatively impact stock prices.
For both, when inflation rises faster than discounted, discount rates rise, reducing the values of both stocks and bonds via the present value effect.
This means that traders/investors may need to consider additional asset classes or strategies, such as commodities or inflation-protected securities, to achieve more robust diversification and protect their portfolios against inflation risk.
China is a risk due to geopolitical tensions
China is currently considered a significant geopolitical risk due to rising tensions with other countries, particularly the United States.
As the world’s second-largest economy and second-largest capital markets, China’s actions can have a major impact on overall global markets, and any political or economic instability in the country can reverberate in other areas.
Many market participants are avoiding China due to these concerns, as well as the country’s regulatory environment and lack of transparency.
Some investors are concerned that the Chinese government may take actions that could negatively impact foreign investors, such as changing regulations or nationalizing companies to revert back to “old ways.”
However, despite the risks, some investors still see potential opportunities in China’s growing economy and rising middle class – as has been the theme for decades now.
It is true that comparable companies in China tend to be cheaper than US and Western-market companies (generally pay about 40% less for the same amount of cash flow).
Is this too much of a discount? Is it too little? About right?
That’s up to each investor to decide.
In general, investing in China requires careful consideration and analysis of the risks and potential rewards, and may not be suitable for everyone.
Illiquidity risk refers to the risk that an investment may not be easily converted into cash when needed.
Many investors have become concerned about this risk, particularly as markets have become more volatile and interest rates rise.
Dual losses on both stocks and bonds have been painful for many long-only investors (which is most).
Shift to private assets
As a result, some investors have shifted their portfolios into more illiquid assets, such as private equity, real estate, and infrastructure.
One reason for this shift is that being long public markets in an environment with rising rates and inflation can be challenging due to the accounting volatility.
Public markets can be more sensitive to changes in interest rates and inflation, which can lead to increased volatility in their valuations.
By investing in illiquid assets, investors can potentially benefit from longer-term returns that are less impacted by short-term market fluctuations.
In the most simple terms, when assets are illiquid during bad market conditions it “hides” the losses.
So, investing in illiquid assets does come with many of the same risks even if their prices are not marked to market.
For example, these assets may be more difficult to value and sell, and investors may have to hold them for longer periods of time than they would with more liquid investments.
Additionally, illiquid assets may be subject to restrictions on when and how they can be sold, which could limit an investor’s ability to access their funds when needed.
Therefore, investors must carefully weigh the risks and benefits of investing in illiquid assets when constructing their portfolios.
Are private assets a good fit for you?
We would say that this is the main criteria for determining whether it’s a good idea to invest in private assets:
- Do you have the expertise? (Many private assets require skills to manage them.)
- Do you have time? (Can you hold something for 10+ years?)
- Risk tolerance (they are not easily sold and not always easy to value)
- Do you have income independent of your portfolio? (These assets are illiquid and may not always produce income in excess of the expenses.)
- Size (private assets are generally best for those with higher net worths, which can lead to privileged access and discounts).
Do you have inflation protection in a portfolio?
Inflation protection is an important consideration for investors when constructing their portfolios, particularly during times of economic uncertainty and rising inflation.
One way to protect against inflation is by investing in assets that have historically performed well during inflationary periods.
Inflation-linked bonds (ILBs) are one such asset class that provides protection against inflation.
These bonds have their principal and interest payments adjusted for inflation, which means that their value tends to rise in inflationary environments.
As a result, they can help investors maintain the purchasing power of their portfolios during times of rising inflation.
Please note that ILBs can also lose value when interest rates rise faster than discounted. They are not inflation swaps.
Commodities are another asset class that can provide inflation protection, particularly those that are less growth-sensitive.
These may include precious metals, agriculture products, and energy commodities. (Energy is generally the most growth-sensitive because it feeds into industrial needs.)
When inflation rises, commodity prices also tend to rise, as their underlying value is tied to supply and demand dynamics.
Investors/traders should be aware that commodities can be volatile and subject to large price swings, so they may not be suitable for all.
Additionally, some commodities may be subject to geopolitical risks or supply chain disruptions, which could impact their performance.
How Diversification Works
Diversification is the practice of investing in a variety of assets in order to reduce risk and increase returns. However, diversification is becoming harder in today’s world due to several factors, including the fact that stocks and bonds are not inherently diversifying.
First, in cases where inflation runs higher than expected, both stocks and bonds can underperform.
Inflation can reduce the real value of a fixed-income security such as bonds, and it can also reduce the purchasing power of the cash flows generated by stocks.
Second, China poses a significant risk due to geopolitical tensions. As the world’s second-largest economy, many traders/investors are avoiding it due to concerns about its economic stability and the potential for conflict with other nations.
Third, illiquidity risk is a growing concern. Many investors have shifted their portfolios into more illiquid assets, such as private equity, real estate, and infrastructure, due to the challenges of being long public markets in an environment with rising rates and inflation.
Finally, investors need to consider inflation protection when constructing their portfolios. Inflation-linked bonds, commodities, and commodities that are less growth-sensitive can help protect against inflation and reduce portfolio risk.