If a poll of investors and investment professionals were to be conducted to determine their ideal investment results, most people would undoubtedly agree: In all economic environments, the total annual return is double-digit.
Of course, they will also agree that the worst-case scenario is the overall decline in asset value. But despite this knowledge, few people can achieve this expected result. In fact, many people have encountered the worst-loss. The reasons for this are many and varied: improper asset allocation, pseudo-diversification, hidden correlations, weight imbalances, false returns, and potential devaluation.
However, the solution may be simpler than you expected. In this article, we will show how to achieve true diversification through asset class selection rather than stock selection and market timing.
- There is a high correlation between the returns that investors receive on the assets they hold and the performance of these assets in the relevant asset class.
- True portfolio diversification is achieved through the selection and holding of various asset classes, not through individual stock selection and timing.
- The ideal asset allocation is not static. The performance of assets and their correlation with each other will change, so monitoring and adjustment are imperative.
- Effective diversification will include asset classes with different risk profiles held in different currencies.
Importance of asset class allocation
According to Gary P. Brinson and Gilbert L. Beebower entitled “Determinants of Portfolio Performance” (1986) (with L. Randolph Hood) and “Determinants of Portfolio Performance II: Update” (1991) (with Brian D. Singer cooperation). This conclusion is also supported by the third study by Roger G. Ibbotson and Paul Kaplan, entitled “Can asset allocation policies explain 40%, 90% or 100% of performance?” (2001).
The latest comments on this topic published in 2020 affirm the benefits of portfolio diversification, focusing on the four core principles of the 2009 financial crisis (law of large numbers, correlation, capital asset pricing models, and risk parity) and subsequent The bull market runs.
This underperformance raises a question. If the US equity growth fund does not always equal or exceed the Russell 3000 Growth Index, what value does the investment management department add to justify their expenses? Maybe it would be more beneficial to simply buy the index.
In addition, research shows that there is a high correlation between the returns received by investors and the performance of the underlying asset class. For example, the performance of US bond funds or investment portfolios is usually very similar to that of the Lehman Composite Bond Index, rising and falling at the same time. This shows that since the expected return will mimic its asset class, asset class selection is far more important than market timing and personal asset selection. Brinson and Beebower concluded that market timing and personal asset choices accounted for only 6% of the change in returns, with the rest made up of strategies or asset classes.
Extensive diversification across multiple asset classes
Many investors do not really understand effective diversification, and often think that they are fully diversified after diversifying their investment to large, medium or small cap stocks; energy, financial, healthcare or technology stocks; and even investing in emerging markets. However, in reality, they just invest in multiple sectors of the stock asset class and are prone to rise and fall in this market.
If we look at the Morningstar Style Index or its industry index, we will find that although the returns are slightly different, they are usually tracked together. However, when people compare the index as a whole or individually with the commodity index, we often do not see this simultaneous directional movement. Therefore, only when holding positions in multiple unrelated asset classes can the investment portfolio be truly diversified and better able to cope with market fluctuations, because the outstanding asset classes can balance the underperforming asset classes.
Hidden associations between asset classes
An effective diversified investor will remain vigilant and vigilant, because the correlation between categories will change over time. For a long time, the international market has been a major market for diversification; however, the correlation between global stock markets has gradually increased significantly in the late 20th century and early 21st century.
After the establishment of the European Union, especially the European Single Market in 1993 and the establishment of the Euro in 1999, it began to develop in the European market. Throughout the 2000s, emerging markets have become increasingly connected to the US and UK markets, reflecting the high degree of investment and financial evolution in these economies.
Perhaps more disturbing is the increase in the previously unknown correlation between the fixed income market and the stock market, which has traditionally been the backbone of asset class diversification. The growing relationship between investment banking and structured financing may be the reason, but on a broader level, the growth of the hedge fund industry may also be a direct result of the increased correlation between fixed income and equities and other smaller asset classes. reason.
For example, when a large global multi-strategy hedge fund suffers losses in one asset class, a margin call may force it to sell its assets across the board, thereby generally affecting all other classes in which it invests.
Asset class adjustment
The ideal asset allocation is not static. As each market develops, their different performance leads to imbalances in asset classes, so monitoring and adjustment are imperative. Investors may find it easier to divest underperforming assets and move their investments to asset classes that produce better returns, but they should pay attention to the risk of holdings in any asset class, and this risk usually drifts due to style Intensified by the impact of the
The prolonged bull market may lead to an increase in asset class holdings, which may require adjustments. Investors should readjust their asset allocation at both ends of the performance scale.
Relative value of assets
Even for experienced investors, asset returns can be misleading. It is best to interpret them in terms of the performance of the asset class, the risks associated with that class, and the underlying currency. One cannot expect similar returns from technology stocks and government bonds, but it should be determined how each will fit into the overall investment portfolio. Effective diversification will include asset classes with different risk profiles held in different currencies.
A small gain in a market where the currency increases relative to your portfolio currency can outweigh a large gain in a falling currency. Similarly, when switching back to an appreciation currency, huge gains may turn into losses. For evaluation purposes, investors should analyze various asset classes based on “national currency” and neutral indicators.
The Swiss franc has been one of the more stable currencies since the 1940s, with a relatively low inflation rate, which can be used as one of the benchmarks for measuring other currencies.
For example, in a year when the S&P 500 index rose by about 3.53%, investors would actually experience a net loss if the depreciation of the U.S. dollar against other currencies was taken into account. In other words, investors who choose to sell their entire portfolio at the end of the year will receive more U.S. dollars than the previous year, but compared with other foreign currencies, investors can use these U.S. dollars to buy less U.S. dollars in the previous year.
When the local currency depreciates, investors tend to ignore the steady decline in the purchasing power of their investments, which is similar to holding an investment with a lower than inflation rate.
Private investors are often caught in the quagmire of stock picking and trading-these activities are not only time-consuming, but can also be overwhelming. It may be more beneficial to take a broader view and focus on asset classes, and the resource intensity will be significantly reduced. With this macro view, investors’ individual investment decisions are simplified and may even be more profitable.