The dangers of inertia
INVESTORS often try to explain the behaviour of capital markets through the lens of natural science. If Newton’s Laws of Motion were repurposed into Laws of Investing, we would understand investors “going with the trend” as creating more inertia, increasing the resistance to a change in direction. Newton’s First Law of Investing would then tell us that the momentum of the price trajectory continues moving in the same direction – unless acted upon by a force. The “first law” is critical: the more inertia, the stronger the force needed to change the direction of the momentum. However, once there is a driving force present, such as the directional force caused by higher interest rates or the random forces of greater economic uncertainty, the trajectory of momentum will inevitably change.
When it comes to the merits of a balanced portfolio, investors may find themselves caught up in the inertia of the masses, with most asset classes suffering negative returns in 2022. While equity and fixed markets have broadly rebounded in 2023, this does not necessarily mean that traditionally diversified portfolios will now deliver on their promise. With the consensus of economists’ forecasts and key market indicators pointing to recession, difficult negotiations to lift the debt ceiling ahead in the United States, and war in Ukraine dragging on, uncertainty continues to dominate the landscape.
Diversification still matters
We begin with a key point of emphasis – now is not the time for investors to give up on the diversification benefits of holding balanced portfolios, those comprised of stocks, bonds and other asset classes. The extreme outcomes of last year, characterised by large, simultaneous losses on all major asset classes, were an anomaly stemming from unexpectedly high inflation and aggressive monetary policy tightening. In my view, those developments have now largely run their course and, as a result, cross-asset correlations are likely to normalise to historical averages, producing the benefits of diversification.
Share with us your feedback on BT's products and services