Seventy-one years ago, Harry Markowitz revolutionized the way individuals and institutions invest by shifting the focus away from individual stock selection and toward building portfolios more broadly. For Markowitz, the stocks a portfolio held mattered far less than the mix of stocks, bonds and other broad asset classes.
Also, long-term profits could be made by holding a mix of assets with different returns under different economic conditions. With the future inherently uncertain, investors should be prepared for what may come next. As others recognized and appreciated these advantages, covariance (how one asset class behaves relative to another over time), rather than absolute return, took center stage.
Since then, relative correlation has become a primary consideration as asset managers determine the specific composition of their portfolios. Armed with decades of historical covariance data, investors try to pick the right mix of stocks, bonds, real estate and other asset classes to optimize long-term returns over business cycles.
History shows that although well-intentioned and well-founded in the past, these portfolios intended to be well-diversified often fail to perform as expected. Covariances that investors assume can be extrapolated into the future are broken down.
Balanced investors experienced this firsthand during 2022, when stocks and bonds fell together. The market’s behavior defied the assurances investors had been given that bonds do well when stocks do poorly.
What these investors and their advisors missed is that the basis of asset class performance and covariance more broadly is investor sentiment. What drives investors to buy or sell specific asset classes over time is not economic cycles, per se, but investors’ willingness to take on certain types of risk—that is, investors’ confidence in the prospects of what they own. As we’ve all seen, this changes frequently, often without warning.
Before the equity and fixed income crashes of 2022, investors had a seemingly insatiable appetite for both stocks and bonds. Prices for both had risen together and were at or near record highs. At the same time that stock investors were stamping on highly futuristic tech stocks, there were trillions of dollars of negative-yielding bonds.
Interestingly, American investors in the early 1980s witnessed exactly the opposite. At the time, interest in both stocks and bonds was cold. With inflation rising, the economy weakening and headlines stagnating, few saw a reason to have one. To a much lesser degree, this was also the case in the fall of 2022.
While historical covariances can help as a starting point when establishing a strategic asset allocation for a portfolio, investors should pay more attention to current sentiment relationships in what they own. Having a portfolio where everything is hot in the eyes of investors can be wonderful on the upside, but its downside will be punishing when sentiment inevitably catches on and reverses. What matters is investment diversification and confidence, not asset diversification.
For this reason, investors should consider owning a mix not of assets themselves, but of moods. Keep both the hated and loved, along with assets with clear uptrends and downtrends. Today, that might mean mixing crowd favorites like Big Tech stocks with unloved assets like energy stocks.
There is more to this type of trust diversification than meets the eye. How we feel influences our preferences. When confidence is high, investors desire futuristic and highly abstract opportunities. When we’re feeling good, we think of concepts like AI as representing limitless possibilities.
On the other hand, when our confidence is low, we abhor abstraction. We demand certainty. Not surprisingly, then, when our mood is low, we reach for cash, gold and other real assets. As a result, a combination of Big Tech and energy represents not only a bullish trade on current sentiment, but also on current investor preferences.
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There are other benefits to trust diversification. It forces investors to take specific actions that go against their behavioral biases. They have to buy distressed assets that they would otherwise not touch because the idea would be ridiculous, while at the same time selling those investments that would otherwise pour money into ever higher prices.
Diversification of trust fosters emotional discipline. Instead of getting swept up in mania or panic, investors look at sentiment objectively and then act on that knowledge. They seek to possess slices of all moods at all times. In a world full of social media and the highly emotional and impulsive behavior that comes with it, trust diversification prevents investors from getting swept away by the crowd. As a result, they are much less likely to overbought at the top and sell out at the bottom.
Markowitz was right that covariance matters and that diversification has benefits. But historical correlations and asset allocation only take us so far. In real time, the relative performance of assets is driven by the relative preferences of the crowd. By better understanding what investors want and don’t want, investors can create more resilient portfolios 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 policymakers on how social mood affects decision-making, the economy, and markets. This article is adapted from Atwater’s new book, The Trust Map: Charting a Path from Chaos to Clarity (Penguin/Portfolio, 2023).
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