Seventy-one years ago, Harry Markowitz revolutionized the way individuals and institutions invest by shifting attention away from selecting individual securities and focusing on portfolio construction more broadly. For Markowitz, which stocks a portfolio holds is far more important than the mix of stocks, bonds, and other broad asset classes.
In addition, long-term benefits can be obtained by holding a mix of assets that perform differently under different economic conditions. With an uncertain future, investors must be prepared for whatever may happen next. As others recognize and value these benefits, covariance—how one asset class performs relative to another over time—rather than absolute returns, takes center stage.
Since then, relative correlation has become a key consideration as asset managers determine the specific composition of their portfolios. Armed with decades of historical covariance data, investors try to choose the right mix of stocks, bonds, real estate, and other asset classes to optimize long-term returns over economic cycles.
History shows that while well-intentioned and well-founded in the past, these supposedly well-diversified portfolios often fail to perform as expected. The covariance that investors assume can be extrapolated into the future breakdown.
Balanced investors experienced this firsthand during 2022 when stocks and bonds fell together. Market behavior defies the assurance investors receive that bonds perform well when stocks perform poorly.
What these investors and their advisers miss is that underlying asset class performance and covariances more broadly is investor sentiment. What leads investors to buy or sell certain asset classes over time is not economic cycles per se, but investors’ willingness to take a certain type of risk — that is, how confident investors are in the prospects of what they have. As we have all seen, these change frequently, often without warning.
As 2022’s equity and fixed income plunge approaches, investors have a seemingly insatiable appetite for stocks and bonds. Prices for both have increased together and are at or near record highs. At the same time that equity investors are getting into highly futuristic tech stocks, there are trillions of dollars in negative yielding bonds.
Interestingly, US investors in the early 1980s witnessed the opposite. Then, interest in stocks and bonds cooled off. With soaring inflation, a weakening economy, and stagflation making headlines, few see a reason to own both. To a much lesser degree, this is also happening in the fall of 2022.
While historical covariance can be helpful as a starting point when establishing strategic asset allocation for a portfolio, investors need to pay more attention to the current sentiment relationship in what they own. Holding a portfolio where everything is hot in the eyes of investors may be great for upside, but the downside will be punishing when the mood inevitably peaks and turns. What is important is the diversification of investment beliefs, not the diversification of assets.
For this reason, investors should consider owning a mix not of the assets themselves, but of moods. Grab the reviled and the beloved, along with assets with a clear up-and-down trend. Today, that might mean pairing crowd favorites like Big Tech stocks with out-of-favor assets like energy stocks.
There is more to this kind of diversification of beliefs than meets the eye. How we feel impacts our preferences. When confidence is high, investors naturally crave highly abstract and futuristic opportunities. When we feel good, we see concepts like AI as representing endless possibilities.
On the other hand, when our self-confidence is low, we hate abstractions. We demand certainty. Unsurprisingly then, when our moods are low, we reach for cash, gold and other tangible assets. As a result, Big Tech and energy pairs represent not only barbell trading in current sentiment, but also in current investor preferences.
There are other benefits of trust diversification. This forces investors to take specific actions that go against their behavioral biases. They have to buy unwelcome assets they won’t touch because the idea would be ludicrous, while at the same time selling investments they should be pouring money into at increasingly higher prices.
Belief diversification fosters emotional discipline. Instead of being carried away by madness or panic, investors view sentiment objectively and then act on this knowledge. They strive to be a part of all moods at all times. In a world flooded with social media and the highly emotional and impulsive behavior that comes with it, diversification of beliefs prevents investors from being swept away by the crowd. As a result, they are much less likely to overbuy at the top and sell at the bottom.
Markowitz is right that covariance does matter and that there are benefits to diversification. But historical correlations and asset allocation only take us so far. In real time, relative asset performance is driven by the relative preferences of the crowd. With a better understanding of what investors want — and don’t want — investors can create portfolios that are more resilient and that move with and against today’s fast-moving crowd.
Peter W. Atwater is an assistant professor of economics at William and Mary, and president of Financial Insights, a consulting firm that advises institutional investors, large corporations, and global policy makers on how the social climate affects decision-making, the economy, and markets. This article is adapted from Atwater’s new book, Map of Faith: Charting the Path from Chaos to Clarity (Penguin/Portfolio, 2023).
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