Diversification is one of the most powerful tools for helping investors navigate the uncertainty of capital markets. It can help limit drawdowns without sacrificing too much return, leading to better portfolio outcomes in the long run. In the context of multiasset-class investing, we believe investors should diversify their portfolios across three key dimensions: risk factors, market regimes and time horizons.
Risk factors are important because investors can expect to earn a risk premium for bearing exposure to systematic risks that are difficult to diversify. By focusing on factors, rather than asset classes, investors can avoid the pitfall of redundant and concentrated risk exposures.
Historically, asset classes have displayed distinct behavior that is highly reliant on the prevailing capital market environment. These market environments, or "regimes," are distinct from one another, shift over time and can be driven by forces such as macroeconomic change, labor market developments and geopolitical events. For example, over the past several decades, we have experienced declining interest rates, low and stable inflation, and a negative correlation between the returns of stocks and bonds, all of which have been supportive of simple, straightforward approaches to diversification, e.g., a balanced portfolio of stocks and bonds. These tailwinds may be abating as we enter an environment characterized by high levels of sovereign debt, peaking globalization, accommodative fiscal and monetary policy, and nominal interest rates near zero. Regime awareness can help protect against an unexpected change.
Time horizon is an important third source of diversification. An effective approach is to combine a long-horizon strategic allocation with a short-horizon active-allocation overlay . This strategy can help protect against the lack of flexibility in a purely strategic approach.