Traditional markets have been uncharacteristically kind to investors over the last decade. AQR Principal and Global Co-Head of Portfolio Solutions Group, Dan Villalon, explains why the next one may disappoint—and what investors’ main options are to meet their return goals.
Over the past few decades markets have gone from somewhat expensive, to historically expensive. This, along with unusually benign macro conditions, led to windfall gains with unusually low risk for traditional asset classes. Additionally, negative stock/bond correlations allowed investors to rely on bond investments for portfolio protection when equities struggled.
Expected returns for many asset classes are currently at historic lows.
So far this year, with stock markets falling and bond yields rising, you might think future returns would look a lot better. Unfortunately, no. Five to ten year expected returns for a range of major asset classes are still a lot closer to all-time lows than anyone would like.
The next decade may be a sharp departure. Even with losses in stock and bond markets year-to-date, expected returns remain low. Inflation risk has also contributed to stocks and bonds becoming less diversifying to each other, leading many portfolios to offer not only lower returns, but also higher risk than investors have become accustomed to.
Inflation risk helps explain why stocks and bonds are becoming more highly correlated.
And it’s inflation risk that explains why stocks and bonds used to be so diversifying to each other and why they appear to be moving more in tandem today. Now the result, is that portfolios that were once appropriate from a risk standpoint are probably too risky today.”
Investors have a handful of options to adapt to the economic environment and the most practical choice may be diversification—specifically adding sources of returns that are currently underrepresented or altogether absent in most portfolios. Crucially, such strategies should have a proven track record of not relying on bull markets for success.
It is important to diversify your diversifiers.
If you are going to do something different – if you’re going to diversify – this is going to sound strange, but make sure your diversifiers are, themselves diversified. Not putting all your eggs in one basket is especially valuable advice when it comes to alternatives investing.
Diversification has always been a key tenet of portfolio management, but investors may find it even more essential going forward. Succeeding unconventionally is never easy, but the case to do so over next decade is historically strong.
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