Sorry about the cheesy title, I still think this would have made better lyrics for the Red Hot Chilli’s song Californication.
Anyway, i’ve previously talked about investing in a global multi asset portfolio or trading in multiple asset classes globally. Why is going global in various asset classes the way to go?
Firstly, why global?
Whether we are trading or investing, the temptation in us all is to be biased towards our home country. In addition to our home country we tend to invest in the large developed countries, i.e the USA. The problem with this is that we are making a heavy bet on that country and if there is some negative news/difficulty in that country, then we are likely to see a large drawdown in our account.
The above concerns a buy and hold approach but the same also applies using other strategies such as long term trend following. With a trend following strategy our account drawdown comes in times when the market is whipsawing. We go long then the market retraces and we sell before the market becomes bullish once more etc. If we are invested in markets in the one country this will hurt our account but say we invested in equities globally, it is less likely the foreign emerging markets will be generating whipsaw signals at the same time as equities in our home country. This goes for Asian equities, European equities, etc etc.
In addition to reducing the volatility/drawdown of our account, going global can also potentially help us to increase returns. Looking at global CAPE values (cyclically adjusted price to earning – a measure of the price of market in question divided by the average of ten years worth of earnings aka shiller P/E), as supplied quarterly here by Star Capital, it is evident to see that some countries are valued much lower than others. Now you just have to look at some of the countries at the lower end of the CAPE scale and they have seen some fantastic returns of recent. Not to say that the countries with higher returns haven’t been performing well but it is much more likely the countries with a lower CAPE will perform better over the next 10 year period than the ones with a high CAPE value.
If general if we invest/trade broadly across several countries globally we reduce our volatility and potentially increase our returns at the same time.
Secondly, why multi-asset?
Well for very much for the same reasons as why it is important to go global, it is very important to trade/invest in multiple asset classes, especially over the long term.
So what is an asset class. Well it is defined as a ‘group of securities that exhibits similar characteristics, behaves similarly in the marketplace and is subject to the same laws and regulations’ by investopedia. The main types of asset class are equities, bonds, commodities, cash and real estate/property.
What these asset classes have in common is that they do not all correlate with each other. The advantage of this, very much like diversifying globally, is that it reduces our volatility. Imagine if you were 100% invested in equities and they take a huge hit, your drawdown could be 50% or higher such as we have had in the S&P 500 in the past decade. If you spread your funds across different asset classes, when equities are taking a hit , generally not all asset classes will be suffering to the same extent so it reduces your losses. This has two big effects, one it is easier to stay invested as most of us can’t take a 50% drawdown before jumping ship, and secondly it means we have less to catchup once the worst is over.
This again works well with a trend following strategy. My long term trend following trading strategy relies on asset classes suffering from the big swings to generate profit but, as stated above, suffers during the times of whipsaw. Not all asset classes will be whipsawing at the same time and therefore by trading/investing in several asset classes we reduce the volatility of our strategy and reduce the drawdown of our account.
In investing the most common way to diversify is by taking an approach of equities and bonds often with the structure of 60% equities and 40% bonds. There is nothing wrong with this, it is a start, but it is not the optimum portfolio. By investing across several asset classes we gain further advantage.
So hopefully I have pointed out here some important things to consider when planning your long term trading/investment strategy. I’ve also discussed how going global across multiple assets affects a buy and hold approach versus a trend following approach and how they are affected differently. This brings me to the last bit of diversification. How about investing part of your funds using a global multi asset buy and hold approach and trading/investing the rest using a trend following strategy. Hopefully you can see again that when the trend following approach is going through some times of drawdown, the buy and hold approach may not be and vice versa. Again, voila, diversification thus reducing your volatility. I discussed a potential way to do this in a previous post learning to love leverage so check it out and let me know what you think.