Why The Recent Impact Of Inflation Has Shown That Portfolio Diversification Is Essential
Now, more so than ever before, the importance of portfolio diversification can’t be overstated.
To diversify your stocks and bonds is to undergo an effective risk management strategy that enables you to invest in a range of different financial assets which can play a key role in reducing the risk of damaging losses occurring.
This can be extremely beneficial during times of high inflation like that of today. As the soaring cost of living is leading to more investor sell-offs of previously strong stocks, diversification helps to ensure that all your eggs are kept in different baskets and are thus stronger during a downturn.
As the record-breaking inflation of today is being impacted by multiple factors surrounding the Covid-19 pandemic and geopolitical tensions, the stocks that are being impacted by the downturn in unprecedented ways – making a diversified strategy far safer over a long term basis.
The Importance Of Diversification
Let’s imagine that you decide to buy stocks in an industry that you believe will have high potential in the future. Share prices are likely to go up as the industry continues to grow, but are liable to go down in the wake of any negative news surrounding the industry and any disruption caused to the companies that operate in the space. In such an event, it’s likely that your portfolio will suffer a significant drop in value if it’s not balanced out by other investments.
When this happens, it can be a good idea to look at what’s causing your chosen industry to struggle. In 2020, the emergence of Covid-19 brought chaos to air travel as international borders were closed and thousands of flights were cancelled.
As a result, other stocks focused on digital entertainment like Netflix and remote communication apps like Zoom rallied as holidaymakers were forced to stay home and interact with friends online. We also saw ‘staycations’ become more popular as lodging marketplace Airbnb’s stock rallied in late 2021 amidst the outbreak of the Covid-19 Omicron variant.
This diversification away from travel stocks ensures that an industry downturn won’t be too impactful across portfolios. It’s also important to diversify among different asset classes. Different assets like bonds and stocks don’t behave the same way to adverse events, and the combination of asset classes like stocks and bonds can reduce a negative response from within your portfolio to adverse market events because they are likely to move in opposite directions. This means that negative movements can be effectively offset by positive ones in different markets.
Another key factor when it comes to diversification is geography. It’s essential to look for stocks and bonds that don’t operate within the same country as others. This means that a domestic financial crisis won’t hurt the entirety of your portfolio.
Playing The Long Game
The stock market can be an extremely mysterious place, and the highest performing assets of today rarely sit still. Whilst stocks are generally the growth engine of portfolios, they also endure many bumps along the way which can see losses accumulate.
As the chart above shows, the highest performing asset classes have varied wildly throughout the 21st Century, and the recent inflationary period is likely to lead to a fresh period of market volatility over the coming years.
“Investors should use a selective overall strategy and not forget about diversification,” noted Maxim Manturov, head of investment advice at Freedom Finance Europe. “This includes an emphasis on quality deals that are based on solid balance sheets and high cash flow generation. Also one of the ways to guard against market uncertainty is to abandon stocks with troubled balance sheets, which benefited from stimulus during the pandemic.”
This can be a difficult approach for investors to come to terms with. After all, if you believe in an industry, you’ll likely find it difficult to move your money into markets that you’re less passionate about. However, it’s these mitigating moves that can keep your portfolio stable when an unexpected negative turn in the industry occurs.
Significantly, many investors have turned to bonds as a type of ballast for a portfolio, with prices rising and falling at a less severe rate than stocks which can help to keep portfolios protected.
Adopting A 60/40 Stocks And Bonds Strategy Can Help
In response to the inflationary pressures facing portfolios worldwide, we’ve seen more investors take on a stock to bond ratio of 60% to 40% respectively. This helps to protect investors from reversals of correlations without the risk of shedding their wealth.
Vanguard data suggests that many investor portfolio asset allocations have been tilting towards stocks at around 80% coverage over 60% – this is an extremely risky strategy to take during times of high inflation and one that could risk devaluing a portfolio.
Fundamentally, portfolio outcomes are determined by investors’ strategic asset allocations. However, this is good news, because it means that well-balanced portfolios can pave the way for investors to continue seeing healthy performance within their assets whilst staying protected from the next challenge set to test global markets.
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