In recent days, certain asset classes have been in high demand, reminiscent of the sought-after spice on the planet Arrakis (as depicted in “Dune” and “Dune 2”). Since the beginning of the year until March 7th, semiconductors and Bitcoin have particularly stood out, with Bitcoin experiencing one of its periodic resurgences, while market sentiment seemed dominated by euphoria and risk appetite across various fronts. Notably, the S&P 500 closed its fourth consecutive month in positive territory, with a staggering growth of +21.5%. However, it’s not just equities that have been on the rise; technology and its derivatives, as well as cryptocurrencies, have also been in the spotlight alongside gold.
Each rally has its reasons: while semiconductors benefit from enthusiasm surrounding the prospects of AI, gold and Bitcoin reflect the widespread unease in this particular phase globally. The fact remains that market euphoria tends to spread exponentially. This rally set may tempt investors to diversify their portfolios across all fronts. However, this approach is strategically flawed, much like fixating on a particular rally. Instead, it’s crucial to maintain a global perspective and diversify. After all, recent geopolitical and economic developments remind us of the importance of robust diversification and balanced allocation.
The key lies in methodical diversification, not just diversifying for the sake of it. There must be a rationale; otherwise, the undeniable and proven benefits are lost.
What is the right level of diversification?
Common sense dictates maintaining composure and spreading risks, even when the impact of this division seems contained. But how much diversification is enough? Naturally, there’s no one-size-fits-all answer for all portfolios and investors. However, data tells us that excessive diversification risks diluting portfolio results without significantly reducing risk.
Essentially, two facts can be considered:
- Every new investment added to the portfolio reduces its overall risk profile.
- However, too many additions, perhaps even hastily made following the current rally, can compress expected returns without offering appreciable benefits in terms of risk mitigation.
So, how should one diversify? By following certain parameters. Among these, the compass of correlation has proven to be immensely useful. But it’s not as straightforward as it may seem at first glance. Let’s delve into why.
Diversification with purpose yields effective diversification. Generally, to achieve a well-diversified portfolio, it’s beneficial to coexist two assets with a negative correlation (or decorrelation). Sounds straightforward, right? Unfortunately, not quite—because correlation isn’t carved in stone.
We often perceive the correlation between two instruments as akin to an adult’s height, once attained, it remains unchanged throughout life. However, correlation, as a concept, is more akin to weight: it can indeed fluctuate. For instance, consider two asset classes whose decorrelation we’ve banked on for years, only to discover they’re not always decorrelated over time. Sometimes, they move in the same direction.
Equities vs. Bonds: Correlation Changes Over Time Take, for example, the 60/40 portfolio, comprised of 60% equities and 40% bonds: for the past two years, this well-established portfolio allocation approach has been on a roller coaster. It was penalized in 2022 due to inflation and the consequent central bank interest rate hikes, more or less recovering since the first half of 2023. And now? The rationale for holding a 60/40 portfolio may still be valid, albeit with the awareness that the situation can evolve and change.
Democratization of finance
For Effective Diversification, analyze correlation over time constructing a balanced portfolio necessitates analyzing instruments and their correlation over time to achieve effective diversification on a case-by-case basis. This strategy shields the portfolio from market turbulence while seizing the opportunities that arise, particularly in equities.
If correlation were immutable, it’d be simple. But because it’s mutable, detailed analysis and profound market knowledge are requisite to optimize portfolio diversification even in the current historical phase.
In the realm of financial markets, accessibility is key. Plus500 in the UK exemplifies this ethos, offering a platform that caters to both seasoned traders and novices alike. With its intuitive interface and comprehensive suite of tools, trading platforms nowadays provide a gateway to the dynamic world of trading, empowering individuals to participate in markets traditionally dominated by institutional players. They are an example of the democratization of finance. Today, there are numerous platforms and tools available to individuals, irrespective of their background or level of expertise. From mobile trading apps to online courses, the landscape has evolved to ensure that everyone has the opportunity to engage with financial markets. Whether it’s equities, commodities, or cryptocurrencies, there are avenues for individuals to explore and capitalize on diverse investment opportunities. This democratization not only fosters financial inclusion but also promotes greater transparency and competition within the industry. As the accessibility of financial tools continues to expand, the barriers to entry diminish, opening doors for a new generation of investors to navigate and thrive in the ever-evolving world of finance.
