While many investors are moving to a more nuanced understanding of risk, old habits die hard. A lot of the multi-asset models sold to investors are based on the assumption that managing volatility and correlation is enough to ensure proper diversification and an appropriate asset mix. We believe that assumption is flawed.
Volatility has become a handy byword for risk. In this view, cash is the safest asset because it has no volatility at all, while assets such as emerging markets are inherently risky. Following this logic, if you combine low volatility assets and high volatility assets in different ways, you arrive at a combination that works for different types of investor.
However, if you are a long-term investor, who needs to grow their wealth by inflation or higher, cash isn’t a ‘low risk’ investment at all. In fact, it almost guarantees that you will not meet your goals. At the same time, if an investor has a longer-term investment horizon, it can be beneficial for them to include some volatile assets to maximise their chances of achieving an inflation-plus return.
At the same time, it assumes the volatility of assets is static, which is a poor assumption. Although we have seen a period of relatively benign volatility recently, that could be derailed by a change in the monetary policy environment, or heightened geopolitical tension, or any number of other factors. To assume that the future will look just like the past is a human instinct but is rarely an accurate guide.
It also assumes that volatility is necessarily bad. Certainly, it can be unnerving, but it can also create investment opportunities: at its most simple, the prices of assets fall, which makes them more attractive. It allows investors to rebalance their portfolios into investments they may not have considered when prices were higher. In this way, volatility can be a real advantage when managing a portfolio.
To see transparent, interactive view of our asset allocation decisions (and reasons why) since the inception of the First State Diversified Growth Fund click here.
Where investors are assuming a low level of volatility into the future, it is also possible to take advantage via protection strategies. These option strategies can reduce tail risks for a portfolio at low cost. During the French elections for example, we added this type of protection. This strategy is particularly useful when there are binary outcomes. Rather than trying to predict the outcome, we instead try and protect the portfolio against the associated short-term volatility.
At the same time a lot of asset models assume a fixed correlation between asset classes. The 60/40 model still forms the basis for many mixed-asset portfolios, for example, particularly among passive investors. Rebalancing to this model assumes that this will always provide adequate diversification because equities and bonds are weakly correlated.
However, it exposes an investor to uncontrolled risks. Regardless of the trends within an underlying asset class, the asset allocation remains the same. This is particularly difficult for passive investments, where the composition of bond indices has changed to incorporate far more government bonds at the expense of sovereign bonds. The duration of passive indices has also moved higher, while yields have moved lower. Investors are taking a whole different set of risks, even if the asset allocation remains the same.