Don’t put all your eggs in one basket. It’s a sensible rule to follow in life, and a golden rule when it comes to investing. And this is the principle that underpins almost every successful investment portfolio.
Traditionally, investors try to spread their risk and smooth out long-term returns by building a diversified portfolio of stocks, bonds, property, alternatives, and cash. But this strategy assumes that the different major asset classes are not closely correlated, meaning they will not rise and fall in tandem.
Research shows that, in fact, asset classes today are more correlated and interconnected than ever before, making true diversification much harder to achieve.
But that old way of doing things might not deliver the robust performance investors want with a level of risk they are happy to accept. A new approach is needed — and that’s where factor investing comes in.
What is factor investing?
Factor investing uses data and the latest technology to analyse those broad, persistent forces that are really driving market returns, harnessing them to generate sustainable returns in the future.
Broadly speaking, there are two types of factors: macroeconomic and style. Macroeconomic factors can include inflation, economic growth, and corporate credit risk. Style might include the size and quality of companies, and whether they are undervalued by the market.
Looking more closely at value stocks as an example, factor investing would show you that those companies that look cheap relative to their true value have tended to beat the market over the long run. This means value is an investment factor that has historically driven returns — and may be worth including in your portfolio.
When you use factor investing, you can find opportunities you might miss if you simply followed the herd. Investors often act irrationally, chasing expensive and risky stocks. But factors can steer you towards a contrarian approach, which could ultimately give you an edge.
Factors each have their own unique qualities, typically performing well at different points in the economic cycle. Because they tend to have low correlations with each other, using more than one factor approach can help you diversify. This is particularly important for people who can’t afford to take a lot of risk with their investments, such as those in or near retirement.
Finding the right balance
When you’re creating a hard-working investment portfolio, these days you’ll need to do more than just hold something from each major asset class and hope for the best. Factor investing gives you deliberate diversification based on real, proven insights.
As markets become more connected, they also become more complicated, and it gets harder to identify the forces driving outperformance. To make sure your portfolio is performing optimally and not just ticking along, you should consider working with a financial adviser who can tailor a portfolio to your income needs and risk appetite. This could help you get the right balance in a world in which some of the old rules of investing may no longer apply.
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Source: Business Insider
Connected markets are forcing a rethink of this fundamental investing rule