Diversification remains one of the most important considerations as investors design their investment portfolios. Asset classes have distinct volatility, correlation, and risk premium characteristics in both recessionary and expansionary periods. Employing long-term historical relationships across asset classes could lead to substantial underperformance when regime shifts happen because volatilities for various risky asset classes tend to be low in equity bull markets and high in equity bear markets.
Investors should pay attention to how they achieve diversification in their portfolios. In recessionary periods, correlations between asset classes rise. Investors need to ensure they shift their asset allocation as regimes change. Capturing this time-varying characteristic is important for obtaining mean-variance portfolio optimization. When the road is smooth and straight, investors can carry as many baskets of eggs as they want to. But when it is bumpy and twisted, investors need to diversify the goods they are bringing to market—adding carrots, corn, and sweet potatoes, for example, in the event that their vehicle drives off the road.
- We use the NBER recession dates to determine whether a period is Expansionary or Recessionary.
- This result is not all that surprising given the well-known fact that NBER cycle definition tends to lag behind capital market movements.
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FEIFEI LI, Director, Head of Research, Research Affiliates, LLC.