Building an all-weather portfolio

Asset classes move in sync during certain market conditions such as credit crisis or political unrest. Such asset price behaviour often prompts investors to question the rationale for diversification. The question is: Why do even “diversified” portfolios decline sharply in certain market conditions and how can investors moderate this risk?

This article explains why asset classes within “diversified” portfolios suffer from synchronous behaviour. It then discusses how to create portfolios considering the sensitivity of asset classes to varying market conditions.

Typical portfolio diversification occurs at two levels — macro and micro. Macro-level diversification refers to allocating assets among asset classes (in some ways, asset allocation is a diversification process). Often, such diversification in retail portfolios refers to taking exposure to stocks and bonds.

Micro-level diversification is taking exposure within an asset class. An investor can take desired equity exposure through, say, large-cap funds and mid-cap funds.

Such a diversified portfolio is cobbled together using either short-run or long-run correlations among asset classes. We call this “synchronous” diversification because such correlations breakdown when the market tanks, prompting most asset classes to move in the same direction.

Consider a portfolio that contains stocks and corporate bonds. Returns on corporate bonds are a function of two variables — change in government yields and change in credit spreads. And change in credit spread, in turn, depends on how well the industry and the economy perform- factors that could also change the price of equity.

In some ways, then, corporate bonds have equity-like characteristics. And they move in sync when such factors are adversely affected. But because of the asset-specific characteristics, stocks and corporate bonds do not move in sync when the economy is strong.

Diversification, hence, fails because correlations among risk factors change depending on market conditions. This makes it important to build a portfolio considering the sensitivities of risk factors of each asset class to different market conditions.

Structural diversification

To construct such a portfolio, we first divide the market into three structures — inflationary, deflationary and conducive-growth. Stocks and bonds often react differently in each of these market conditions.

Inflationary condition is when there is high inflation with little growth. Such a situation hurts both stocks and bonds. Deflationary condition occurs during market crisis when economy either slows down or slips into recession. Such a condition is bad for stocks but good for bonds as interest rates decline and remain soft. And, finally, the conducive-growth condition is one where the economy grows with moderate inflation. Such a situation is good for stocks and can be good or bad for bonds depending on the level of inflation.

The diversification process should consider all three scenarios for building the portfolio. Consider the inflationary scenario. Suffice it to know that commodities tend to perform well during high inflation conditions. An investor should, hence, have exposure to commodities, preferably through commodity futures. Sometimes, investors take exposure to stocks of companies in the commodity business. Such exposure is subject to equity risk and is, hence, not preferred.

Consider next the conducive-growth scenario. Investors should consider corporate bonds and stocks, as these assets are expected to do well during good economic conditions. And finally, consider the deflationary or minimal-growth scenario. As this happens during a time when investors do not have confidence in the economy, there is often “flight to quality”.

Thus, government bonds and gold typically move up while other asset classes edge down. We call this process as “structural” diversification.

The creation of diversified portfolio is not complete till the investor decides on the asset allocation. The asset allocation strategy would depend on probability of each market condition during the investor's investment horizon, and risk tolerance.

For instance, those who are aggressive and have a longer time horizon may consider a larger allocation to the conducive-growth scenario while those having a shorter time horizon may allocate more to the inflationary scenario. Such a structurally diversified custom-tailored portfolio can increase the likelihood of an investor achieving her desired investment objectives.

The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can reached at >enhancek@gmail.com )

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