By John Lunt via Iris.xyz
The principal of diversification drives asset allocation for both institutional and individual investors.
The benefits of diversification do not come from simply adding more investments to an asset allocation, but rather, from adding investments with lower correlations to existing investments within the allocation. However, a prospective investment may have a higher correlation to existing investments, while still bringing desirable attributes like the potential for lower volatility, downside protection, or upside outperformance. Ultimately, investors hope to generate more return per unit of risk. Return requires risk, and we believe that risk is either derived from the asset class (market risk or market beta) or from the manager (strategy risk).
In most asset allocations, the equity portion represents the majority of the total risk. Fixed Income is used to lower volatility and to cushion portfolio drawdown.
Today, many investors are concerned about how public policies (particularly monetary policy) have distorted returns for both equities and fixed income. This has raised concerns about potentially high valuations for equities while at the same time fueling worries about the potential for rising rates and widening credit spreads in fixed income. In short, investors are worried about “market risk.” With heightened concerns surrounding market risk, it seems natural for many investors to seek additional ways to diversify portfolios.
In this quest for diversification, investors may ask: what does not necessarily correlate with market risk or market beta? The answer: active investment decisions or investment strategy.
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