Is It Time To Embrace Portfolio Diversification Again?

Is It Time To Embrace Portfolio Diversification Again?
Stéphane Renevier, CFA

over 1 year ago2 mins

Stubbornly high inflation has forced the Federal Reserve (the Fed) to aggressively raise interest rates. That’s led to something very unusual (and unfortunate, from a portfolio diversification standpoint): stocks and bonds are both down this year, for only the third time since 1926.

Can they both continue to go lower? In the short-term, sure. As long as stubbornly high inflation forces the Fed to keep hiking rates despite the slowdown in the economy, both are likely to stay under pressure. It won’t last forever though: if the Fed is hiking rates aggressively, it’s doing so to slash demand (remember, the Fed can’t target the supply) by so much that it’ll crush inflation. And the Fed won’t stop until it’s sure that the job is done. In other words, inflation will go lower, but the question is how hard the economy will be hit in the process.

On the one hand, if the economy collapses, bonds should do well. At some point, a fall in overall economic demand would be expected to bring inflation lower and allow the Fed to pause its hikes. It’s not a pretty environment, but it’s one in which bonds would perform well: they’d not only benefit from investors fleeing risky assets, but also from falling interest rates and lower inflation. On the other hand, if the Fed does achieve the perfect “soft-landing” scenario (raising interest rates just enough to nudge inflation lower without tipping the economy into a recession), then stocks should fly, benefitting from renewed risk appetite. Either way, one of the two assets (and over the long-term most likely both) will probably perform well again.

If you’ve got a strong view on how well the economy will handle those interest rate hikes, then by all means concentrate on the asset that should perform best in your scenario. But if you want to avoid choosing a side, now may be a good time to embrace portfolio diversification once again, and start buying bonds to hedge some of the risk from your stocks. It’s when both assets were hitting new highs that diversification was at its most risky, not now that they benefit from an increased margin of safety.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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