We have learned through our years of experience in the markets that the only "free lunch" in investing or trading is provided through diversification. More specifically, an investor can reduce downside risk in his or her investment portfolio AND keep the bulk of expected returns by properly diversifying into incremental return streams that are uncorrelated to each other (i.e. they zig and zag in ways that balance each other out).
Note: A "return stream" is essentially any way of generating financial gains, whether through a job, a private business, real estate, stocks and bonds, or active trading strategies.
To simply show how this works, we can consider a store that sells kayaks and snowboards. The owners of the store know if they only sell kayaks, the store will only be profitable in the spring and summer, when people are buying kayaks. Similarly, if they only offer snowboards, their success will be limited to the fall and winter months. Therefore, the optimal solution is to diversify and invest in both product lines, stocking the store with kayaks for the warmer months and snowboards for the colder months. As each product line is uncorrelated with the other, this solution not only lowers the volatility of the store's sales, but also increases its overall revenues. To better illustrate this dynamic, we have provided Figure 1 below.
Figure 1: Kayak and Snowboard Sales by Year
The same effect holds true in financial markets with uncorrelated investments. For instance, certain return streams perform well in times of economic growth (stocks and real estate), while others tend to perform well during times of economic decline and uncertainty (treasuries and gold). Also, there are strategy-based return streams that benefit from low volatility and trending markets (i.e. passive buy-and-hold, trend following, and momentum), while there are others that successfully exploit higher volatility and oscillating markets (i.e. mean reversion and options trading). By investing across a balanced portfolio of these uncorrelated return streams, investors can lower their volatility and increase their expected returns across market cycles and economic environments, just like the store example above.
However, the key to effective diversification is the combination of minimally correlated return streams. To show how important the degree of correlation is in reducing portfolio risk, we have provided Figure 2 below, which mathematically shows how much risk can be diversified away by incrementally adding return streams with different correlations. For example, if an investor constructed a portfolio of 20 or more return streams, each with 75% correlations to each other, the portfolio's risk could only decline by 10-15%, at most. On the other hand, if the same investor built the portfolio with uncorrelated return streams (25% or less), he or she could reduce the portfolio's risk by 50-80%, or more!
Figure 2: Potential Risk Reduction Based on Number and Correlation of Return Streams
As indicated in the chart above, from a risk standpoint, it is clearly advisable for investors to seek out truly uncorrelated return streams to add to their portfolios, as each incremental investment would improve risk-adjusted returns. In fact, this is exactly what most institutional investors strive to achieve. However, in most traditional investor portfolios, achieving optimal risk reduction is often eluded, as these portfolios are typically dominated by highly-correlated investments, most notably U.S. stocks, international stocks, and real estate, all of which have correlations to each other of 75-90%. Moreover, these investments are often highly-cyclical, meaning they increase and decrease in value in lock-step with the health of the broader economy. As a result, investors in traditional portfolios are often punished twice-over, as economic weakness tends to lead to portfolio declines at the same time the investors may be experiencing wage decreases or layoffs, lower business profits, and potentially defaults on outstanding debt. In short, their portfolios add incremental pain when it already hurts to be hurt.
At RQA, we firmly believe in taking diversification a step further through multi-dimensional diversification across a wide array of alternative return streams. We cultivate and properly balance a growing portfolio of proprietary strategies, which are diversified across global asset classes, time frames, and strategy dynamics (e.g. long/short, momentum/value, trend/counter-trend, risk parity, etc.). Through this, we seek to provide more consistent and reliable returns to our investors across market environments, while actively managing downside risk.
Disclaimer: These materials have been prepared solely for informational purposes and do not constitute a recommendation to make or dispose of any investment or engage in any particular investment strategy. These materials include general information and have not been tailored for any specific recipient or recipients. Information or data shown or used in these materials were obtained from sources believed to be reliable, but accuracy is not guaranteed.