You’re flying over a capital city and there is a traffic jam below. It has no impact on you reaching your destination. That’s because the two modes of transport have no correlation. What happens to one does not impact the other.
To go a step further, the plane may be in a favourable tailwind, so it goes faster without any additional effort and reaches its destination sooner. In investment terms, its outperformed expectations.
Down in the traffic jam there are two workers in separate cars trying to get to work. They are impacted by the same event, so their correlation is very high, they are both going to be late for work, and their productivity will fall.
The analogy fits easily into an investment portfolio.
We may own shares in two different companies, and each company may be operating in an unrelated field, say healthcare and logistics.
A strike by truck drivers may impact the logistics company, but have minimal impact on the healthcare company. That’s good, by spreading our investments we can counteract the impact on an individual investment.
While our overall return from both companies will be lower, due to the poor performance of the logistics company, it would be a lot worse if it was the only asset in our portfolio.
However, an event that lowers the share market across the board means both of our investments will fall.
To counteract this we need investments that operate on different drivers to the share market.
Types of investments we look for include:
- Investment grade corporate bonds
Bonds offer a reliable source of income through dividends payments across the business cycle. The risk with corporate bonds in that the issuer defaults, however, default amongst investment grade corporate bonds is rare.
According to S&P’s 2019 Global Ratings annual default transition study, the last investment-grade corporate bond default was in 2016, and prior to that it was 2011. Speculative grade bonds can deliver higher returns, but carry substantially higher risk.
Whether it’s a residential or commercial property investment there is little correlation to the share market. As a long term investment secured by leases, property tends to be less impacted by larger macroeconomic events.
You can also enter property through listed Real Estate Investment Trusts (REITs). Property tends to be a good hedge against inflation, as it performs well in inflationary environments.
As the ultimate safe haven currency, gold performs well when risk and uncertainty are the prevailing driver’s behind investor’s decisions - like in the midst of a global pandemic.
There are many ways to get an exposure to gold, including physical holdings, Exchange Traded Funds (ETF’s) or shares in a producer.
Each choice of exposure offers different levels of correlation. Physical holdings offer low correlation to share market drivers, whereas shares in a gold producer are highly correlated.
The go to investment when you just need to park some cash for a while. While cash has no correlation to the share market it is correlated to bonds, as both are driven by interest rates.
Where to now?
There are many other forms of investment that may offer diversification and non-correlation, including hedge funds, mutual funds, emerging market bonds and collectibles.
To get started you need to first decide how much income you need from your portfolio and plan for it, whether it be in the form of bonds, share dividends or interest on cash.
You can then allocate to higher return assets based on the level of risk you are prepared to accept in your portfolio, which should also reflect your age. The aim should always be to grow your portfolio over the long term, while maintaining the cash flow you require to sustain your lifestyle. and meet future expenses.
Allocating preferably to high return assets can be tempting, but in times of high volatility it pays to chart a safer course that protects your wealth and legacy.
Damon is the Content Editor for Citi
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