Through investing, we systematically counter risk. Examples of known risk include inflation, boom and bust cycles, currency movements, new governments and even war. Unknown risk includes scenarios we’ve not seen yet — COVID was an unknown until recently.
To solve this, we use a diversified portfolio (your eggs in multiple baskets) across asset classes — a combination to counter every risk above. In an ideal world, we should have all the instruments to address this, but we don’t.
We only have a few asset classes, but they address a disproportionate amount of known risk.
Asset classes and their long-term characteristics:
- Cash and fixed income: This provides stability in returns, but there is limited protection against inflation.
- Equity: This helps counter inflation, and also rides the wave of economic expansion.
- Commodities (except Gold): These amplify the equity effect. Counter inflation and ride economic expansion more than equity, and also, suffer more during a downturn.
- Gold: This helps counter inflation, but performs tangential to equity during a downturn.
There are other asset classes, such as real estate, venture capital, art etc. All of these fall into one of the above buckets. For instance, real estate is similar to equity — the value of a property grows with inflation, and with the economy and vice versa.
Known risks occur along two axes — inflation and growth.
Each asset class plays a distinct role during such scenarios. In an ideal situation, if we were able to predict, we should be able to move from equity during a growth phase to fixed income during a downturn — sell equity and buy fixed income in one move when we identify the stage. But every risk phase is in flux — you never know when you have entered it until everybody knows. And, by then, you are already too late. The simple thing to do is never to miss anything and get all the asset classes in your mix.
Diversification is the only free lunch that the market offers.
Thus, to counter risk, we need a combination of these asset classes. These asset classes work exceptionally well in specific scenarios, but not in the others. Still, they come together to deliver more than the sum of their parts, across all scenarios (we’ll throw in some charts next time).