Diversifying investment portfolios has always been a crucial aspect of successful financial planning. Traditionally, the combination of stocks and bonds provided a reliable means of diversification, with their inverse relationship acting as a cushion during market downturns. However, the year 2022 challenged this conventional wisdom as both stocks and bonds faced simultaneous declines amidst soaring inflation. This article delves into the evolving landscape of portfolio diversification and introduces trend following as an alternative strategy available to UK investors.
The Changing Dynamics of Portfolio Construction
For the past two decades, constructing diversified portfolios seemed straightforward due to the inverse relationship between stocks and bonds. During times of market turbulence such as the Dotcom Bubble, the Global Financial Crisis, and the Covid outbreak in 2020, bonds served as a safety net, mitigating losses in stocks. This correlation, combined with the rise of passive index-tracking investment products, allowed investors to construct cost-effective portfolios tailored to their risk tolerance and investment horizon.
This approach proved successful in the years following the 2008 Global Financial Crisis. However, in 2022, a paradigm shift occurred. Inflation soared to its highest levels in forty years, causing both stocks and bonds to decline simultaneously. Adding to the challenge, rising interest rates led to “safe” bonds underperforming “risky” stocks. This positive correlation between stocks and bonds may not surprise those with a longer-term perspective, as historical data indicates that prior to 2000, such positive correlation was the norm.
The Quest for Genuine Diversification
UK investors have historically faced limited access to genuine alternative investments, which were primarily available to institutional investors and high-net-worth individuals. However, the investment landscape is gradually evolving, offering new opportunities for diversification. Enter trend following, a strategy that aims to capitalise on major price trends across commodities, currencies, stock indices, and fixed income.
This strategy’s appeal lies in its ability to generate diversifying returns, particularly in challenging market environments where traditional portfolios face difficulties.
As investors seek to navigate uncertain times, incorporating trend following into their portfolios can enhance diversification, mitigate risk, and potentially improve overall investment outcomes. Embracing alternative strategies like trend following enables investors to adapt to evolving market conditions and seize opportunities for growth and stability.