Risk & The World Economy
As investment managers, our focus is on trying to provide the highest level of return possible per unit of risk we assume on behalf of our clients. And, 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 task has been relatively easy, but as the world becomes more connected and countries grow more and more codependent, we’re able to control risk less and less. What does this mean for the individual investor? It may mean that the increase in portfolio volatility we have been experiencing lately is here to stay.
Diversification distributes 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: diversifying away the risk of a decline in any one asset class by investing in different asset classes with low levels of correlation.
We know we need to use different baskets, but how do we know which ones?
Choosing baskets comes down to their correlation, 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 find different assets (baskets) that progress toward their own individual expected returns completely independent of one another. In today’s world, this is becoming increasingly difficult.
Increased connection leads to more correlation and more volatility.
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. There is stronger interdependence between countries and, so, stronger correlation between global economies and asset classes, which leads to more volatile markets and portfolios.
If the potential impact of globalization wasn’t apparent before, the last few years have surely been a reality check about just how interconnected we are. With the pandemic slowing job markets, supply chains, travel and trade, at home and abroad, we’ve had our hands full worrying about economies around the globe and the lingering effects on our ability to move forward.
The new reality is that asset correlation is a much larger part of the overall equation than it once was, especially as the fallout of COVID-19 continues to test the market. Diversification is still the best tool we have for controlling risk within investment portfolios. 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 be working harder to identify and take advantage of opportunities to minimize risk.
This material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.
