As investment managers, our focus is on trying to provide the highest level of return possible per unit of risk we assume. Because each investment account has a different tolerance for risk we need to be able to adjust and calibrate that risk at will. Historically this has been relatively easy, but as the world becomes more connected and countries more co-dependent, this task has become more difficult. What does this mean for the individual investor? It may mean that the increase in portfolio volatility we have been experiencing lately may be here to stay.
We all understand the idea of diversification, distributing risk by not “putting all your eggs in one basket”. This is the primary tool we employ to control risk in a client’s portfolio. We work to diversify away the risk of a decline in any one asset class by investing in different asset classes that have low levels of correlation. Yes we need to use different baskets, we can all agree on this, but which baskets do we use?
Choosing baskets comes down to how they correlate, or better yet, their lack of correlation. Every asset class has its own expected return (ER), the positive return we expect to receive from that type of asset over time. In an ideal world we would be able to find different assets (baskets) that progressed towards their own individual expected return, and did so completely independent of one another. In today’s world this is becoming increasingly difficult.
We live in a world where information travels at the speed of light, where raw materials are sourced from locations around the globe, and something as simple as a t-shirt may travel thousands of miles during the manufacturing process, affecting several economies on its way to your drawer. This has created more economic interdependence between countries and strengthened the correlation between global economies.
Diversification is still the best tool we have for controlling risk within investment portfolios, but there are times and situations where the correlation between asset classes strengthens as a result of this global interdependence. As a result, we see more volatile markets, and portfolios.
This year has been a great example of how the global economic situation plays a large part in how our market performs here at home. Between Greece, the EU, and China, we’ve had our hands full worrying about economies around the globe and the effect their futures will have on our ability to continue to move forward.
The new reality is that this is a much larger part of the overall equation that it once was. As we continue to become more of a global society, the correlations between certain asset classes will continue to strengthen and as investors we will certainly need to work harder to identify and take advantage of opportunities to minimize risk.
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