As volatility returns to markets, single asset class exposure can be more vulnerable than a diversified, uncorrelated asset mix. Here are some things to consider.
While two adages often applied to investing - don't keep all your eggs in one basket and stick to your knitting – seem to contradict each other, volatile markets often highlight the vulnerability of sticking to a single asset class or instrument.
Traders should always fully understand the instruments they trade, and there is a propensity to stick with an asset class you are well versed in.
However, the successful trader never stops learning and there are a myriad benefits to consider building a multi-asset portfolio, balanced to reflect a unique risk profile and investment goals.
What does this mean for traders?
Protect against losses, particularly during volatile market conditions. Traders consider asset allocation (mixing a range of uncorrelated asset classes) as a hedging strategy.
According to portfolio theorist Professor William F. Sharpe, the specific mix of different asset classes and weightings to investments within each asset class accounts for 91% of investment performance.
Finding the right balance between return and risk when allocating assets is seen as key to achieving trading objectives. Photo: Shutterstock
The benefits of a multi-asset portfolio:
- Diversifies risk – mixing uncorrelated assets spread across a number of classes means that when one asset class in a portfolio decreases in value, another asset class is more likely to outperform, reducing and balancing a portfolio's overall risk profile.
- Drives returns – as the performance of different asset classes vary over time, so does the return. By selecting a mix of assets, one is able to maximise their portfolio's overall return rate through establishing more than just one revenue stream from it.
Which assets to include?
A diversified, multi-asset portfolio can draw from as many asset classes as a trading platform permits.
These may include:
- Cash equities
- Commercial and residential real estate (including Real Estate Investment Trusts - REITs)
- Derivatives (futures and options)
- Investment Trusts
- Foreign exchange/FX (both spot and options)
- Commodities (e.g. precious metals like gold and platinum as well as energy)
- Contracts for Difference (CFDs)
- Money market instruments
How to choose the right asset allocation mix:
There's no correct formula. Allocating the right asset mix depends on each individual's approach to and motivations for investing in capital markets. For example, one may want to consider:
1) Short/long term goals
2) Investment timeframe
3) Risk tolerance
4) Different instrument types:
- Active (buying and selling of financial instruments)
- Passive (securities that automatically track the broader market; e.g. Exchange-Traded Funds/Commodities
5) Consider a 'style'; how to approach trading:
- Tactical Asset Allocation (TAA). The portfolio's original strategic asset mix can be changed dynamically in pursuit of short-term profits. The investment time horizon is unconstrained and can be daily, weekly or monthly.
- Strategic asset allocation. Tends to be less active than TAA
Asset allocating is not just a one-off technique, rather an evolving life-long process of tinkering, tailoring and adjusting in order to seek the desired rewards.