Investors have been on heightened alert for risk since the financial crisis of 2008 but rather than be generally risk averse, it’s wise to have a plan to manage it.
Bond prices are near all-time highs and interest rates remain at record lows. Twice since 2000, equity markets have lost over 40%. Prices of real-estate investment trusts (REITs) are at their highest in five years.
Gold prices have sextupled since 2000. Investors have to view risk as more than spreading assets over traditional asset classes.
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They need to think differently about diversification—literally. Diversification most appropriately should be thought of in terms of choosing different exposures to risk. This means considering exposure to certain economic risks including expansion, recession, inflation, and deflation.
Traditional diversification can unwittingly overexpose investors to similar asset classes, even though different mutual fund companies and asset managers may be chosen.
Financial planners traditionally use historical correlations in designing asset allocation strategies.
But in 2008, the markets defied traditional approaches and completely ignored diversification theory.
Correlations can also change. During the 1980s and 1990s, Treasury bonds and US stocks tended to move in tandem. During the 2008-2009 credit crisis, bonds and stocks moved in opposite directions.
Being smart about diversification only makes sense. If the world is changing through globalization and the markets are being influenced by investor behavior and high-speed trading, it seems silly to think that traditional diversification
is going to do the job.