The most dangerous phrase in investing is said to be "It's different this time".
Markets are driven partly by emotion, by politics and natural disasters: there will be other crises. We may hope they won’t be as systemic as 2008’s, but history shows our ability to innovate – to create new opportunities for profit and loss – exceeds our ability to regulate. When the next crisis hits, asset correlations within a portfolio will shift again.
We suspect crises are not different this time – they’re subtly different every time. Meanwhile, the case for diversification is no more hurt by the runaway performance of developed stocks in 2013 (so far) than by the stand-out rise in bond prices in 2008. Investors would have done best this year by owning nothing but developed stocks – just as they’d have done best by owning only government bonds in 2008. Hindsight has 20:20 vision. Unfortunately, our ability to predict the winning assets each year is not what we’d like. We give it our best shot, but the changes in asset class returns from year to year reminds us how difficult it is to pick the winners .
Diversification is a little like house insurance: peace of mind is worth having, even if your home doesn’t burn down. Falling correlations within risky assets can influence the way in which investors express their views on markets. If sectors and countries are moving less closely together within developed stock markets, for example, the potential ability of fund managers to add value by actively selecting stocks and sectors might rise by comparison with a world in which most sectors and countries are rising together. In the less correlated world, investors may be more inclined to opt for an active fund; in the latter, opting for a passive fund that simply tracks the wider market may perhaps be the obvious thing to do.
That said, we think that there is still sufficient headroom in developed stocks for passive implementation approaches to continue to deliver attractive risk-adjusted returns from developed stocks. Stocks have the biggest weights in most balanced portfolios, and are one of the most volatile assets. The interaction between stocks and government bonds is probably the most important driver of overall portfolio returns and volatility. Their correlation has rebounded sharply – from being very negative, to positive – and may rise further in the months and years ahead. This will reflect a further unwinding of crisis-induced flows, and on a long-term basis we see the “natural” correlation between stocks and bonds as more likely to be positive, as in the more distant past, than negative.
:: Andrew Miller is a director of Barclays Wealth and Investment Management in Newcastle