The key to being a successful investor is understanding how an investment is correlated to the general market performance. You need to have an idea of how it is likely to perform in a bearish and a bullish market.
Covid-19 has brought about economic turbulence characterized by increased volatility across various assets. Adopting uncorrelated returns strategies can help you to get consistent returns by diversifying your portfolio of investments. Read on to understand why you need to add uncorrelated returns to your portfolio in 2021.
For capital preservation
Building a portfolio of investments by considering uncorrelated assets is a proven way of capital preservation. Experts have achieved the capital preservation goal by adopting the 60/40 portfolio because it is believed that bonds and stocks’ prices move in the opposite direction.
The year 2021 is marked by a lot of uncertainties in the price movements of assets. If the stock market is experiencing a downturn, bond prices are likely to rise. If you wish to retire during a downturn, you can sell your bonds, protect your stock holdings, and get some capital gains. When the time of economic recession is over, you will have sufficient capital to invest in both bonds and stocks.
You will avoid selling your stocks at low prices despite that economic recovery may take a long time. Selling bonds may be a good idea because when the stock market is not doing well, the bond prices are high. It is a great strategy to enable you to earn some retirement income because you will have a long-term perspective in mind.
Capital preservation is an important aspect of any long-term investment and attaining optimal investment outcomes. Having alternative investments to your portfolio is important, but you also need to consider an investment’s liquidity.
It is difficult to eliminate systematic risk because it is inherent to a market segment or the entire market. However, this risk can be reduced by carefully allocating funds to a wide range of assets. As long as the assets are uncorrelated, a diversified portfolio can reduce the returns’ volatility in the long run.
Common systematic risks that you can reduce using uncorrelated returns include:
- Market risk– This arises due to the tendency of investors to respond to market changes.
- Interest rate risk– Arises due to fluctuating interest rates in the market.
- Political risk- This risk occurs due to political instability in a region or country.
- Exchange rate risk– This occurs due to the uncertainties in fluctuations in currency value. It influences companies dealing with foreign exchange transactions.
- Inflation risk– Inflation risk occurs as a result of erosion of the purchasing power of money
In negative and volatile markets, the correlation between investments tends to increase, minimizing the benefits of diversification. Any strategy in a diversified portfolio must have a low correlation with the rest of the portfolio’s assets to reduce the portfolio risk.
During difficult economic times, including what is happening during the COVID-19 pandemic, uncorrelated assets may look like they are nowhere. However, investment diversification serves its purpose despite that this may not provide complete assurance of investment safety.
Diversification has the potential for high returns. Use negative correlations with portfolio risk management to allocate assets in your portfolio. You can diversify the risks of your portfolio if you invest in uncorrelated assets. This strategy can work well during periods of high volatility or if you forecast a market crash. The idea is to manage the portfolio risk and invest in assets that will yield a low volatility portfolio.
Store of value
One of the reasons for hoarding money is because it can be used as a store of value. A great example of a store of value is an investment in metal such as gold because of perpetual shelf life and price stability.
When you keep part of your portfolio of investments in a safe store of value, you can overcome economic downturns. It can also offer you the benefit of liquidating the investments on need.
Uncertainties surround the market in 2021. If you kept investments in stores of value such as gold, you could be part of the economic recovery in a great way. If you did not have cash at the beginning of 2021, you cannot take advantage of reduced equity market prices now.
Including stores of value such as gold can help you with an inflation hedge because its price increases with an increase in living costs. During high inflation, prices of precious metals increase while those of the stock market plunge. Hoarding money as a store of value offers the benefit of deflation protection.
During the depression, the purchasing power of precious metals sores while other prices drop rapidly. This is because people prefer to hoard cash by investing in these precious metals such as gold. Such an investment can retain its value during geopolitical uncertainty and financial uncertainty.
As an investor, you need to consider the risk-adjusted returns that measure the portfolio returns against perceived risk. You should be able to achieve more returns per unit of risk. The portfolio’s risk-adjusted returns can be improved by including uncorrelated assets regardless of whether they have equal expected returns.
Including low correlation, assets can lower the portfolio volatility that is being experienced in 2021. Using uncorrelated assets to improve risk-adjusted returns is worthwhile even when the traditional assets’ returns are positive. Predicting the future is difficult, but you can focus on identifying the classes of assets whose returns are uncorrelated with the traditional markets.
You can pursue a balanced portfolio consisting of assets that have contributed to the overall performance of firms. Uncorrelated asset allocation with attractive returns improves the risk-adjusted returns and improves investor confidence.
Investors can hold onto volatile investments during an economic downturn instead of liquidating investments at the wrong time and suffering losses. Adding uncorrelated assets with similar volatility features can significantly reduce the ultimate volatility of the combined assets.
The cornerstone of modern portfolio theory is portfolio diversification. During a market downturn, like what has been experienced in the year 2020 and the first quarter of 2021, a well-diversified portfolio can outperform an undiversified one.
The economic crisis that is being experienced globally is inevitable. You can protect your assets by reducing the systematic risk through non-correlating assets such as currencies, real estate, commodities, collectibles, and bonds. Asset options depend on your risk appetite and investment strategy.
Uncorrelated assets react to changes in market environments differently from stocks. They can reduce the volatility of your overall portfolio. Using uncorrelated assets helps to eliminate the highs and lows in investment performance, offering more balanced returns. You can reduce the downside risk you can take in a bullish market while you thrive in a bearish market.
2021 is the time to add uncorrelated returns to your portfolio due to uncertainties and asset volatility. Investing in a portfolio of assets can help in capital preservation, risk reduction, investment hoarding, increased value, and asset protection. Uncorrelated strategies can work well in 2021, especially if you are seeking long-term investment with greater returns. You need to pay attention to other factors that may influence investment decisions before investing.
Charlie Svensson is an extremely talented and experienced college paper writer working as a freelancer for some very good writing agencies in the US and UK. He covers a wide range of subjects, and some of his favorites include training and development, management, finance and economics, and technology. He’s currently planning to start a writing blog for his audience.