3 Asset Classes That Could Raise Your Portfolio’s Risk Level

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton.

Different asset classes bring their own diversification benefits and risks to portfolios. Investors looking to hedge their bets can turn to non-US stocks, commodities, and crypto. How have these assets performed in the past few years? And what should you know if you’re considering adding them to your portfolio? Three Morningstar researchers examined that in the 2024 Diversification Landscape report. Amy Arnott is one of the co-authors and a portfolio strategist for Morningstar Inc. Here’s our conversation.

Thanks for joining me, Amy.

Amy Arnott: Great to be here.

Benefits of Diversifying Beyond US Stocks and Bonds

Hampton: Let’s start with the benefits of diversifying beyond US stocks and bonds.

Arnott: One reason is to make sure you have exposure to a variety of asset classes because you never know what’s going to be in favor or out of favor in any given year. So, holding a diversified portfolio can help you mitigate the risk of being overexposed to any one particular area.

Holding a diversified portfolio can also help reduce your portfolio’s overall risk profile. So, if you are holding assets that have less than a perfect correlation, if their correlation coefficient is less than 1.0, that can help reduce your portfolio’s overall level of risk.

Which Asset Classes Didn’t Move in the Opposite Direction of Stocks?

Hampton: Diversifiers are supposed to move in the opposite direction of stocks, right? Which asset classes did your team find that really didn’t do that?

Arnott: First, I would say it’s very difficult to find asset classes that move in the opposite direction from stocks. If they did that all of the time, that would be a correlation coefficient of negative 1.0.

Almost every asset class tends to be affected in some way by broad macro trends, things like inflation, interest rates, overall economic growth. So, usually, the correlation coefficients that we find between different asset classes are above zero, but we’re just looking for correlations that are below 1.0. And basically, the lower the correlation, the greater the diversification benefit when you’re adding to a portfolio. And the goal is really to, as I said, reduce the portfolio’s overall risk profile and also gain exposure to a variety of areas in the market.

Hampton: Any asset classes that didn’t really move in the opposite direction?

Arnott: I would point out three areas. One would be high-yield bonds, which are also known as junk bonds. These are bonds that have below-investment-grade credit ratings. They typically have weaker balance sheets, so they’re more exposed not just to the company’s performance but also to overall economic growth trends. So, if there is a downturn, they tend to behave more like stocks and actually have a fairly high correlation with the overall stock market.

Another area I would highlight would be real estate, including real estate investment trusts. So, a lot of people hype up real estate as a good way to diversify your portfolio, and that was definitely true during some periods in the past. But I would say over the past 10 or 20 years, we’ve seen a pretty steady increase in correlations for real estate, so you’re really not getting much of a diversification benefit, especially not as much as a lot of people might expect.

And then the other area I would highlight is cryptocurrency because these are digital assets that are very different from any type of traditional asset class, like stocks or bonds or other commodities. So, they’ve historically had very low or even negative correlations with most traditional asset classes, but that trend has started to change as we’ve seen a bunch of spot bitcoin ETFs come into the market this year, and more institutional investors have been adopting cryptocurrency, so crypto is moving more into the mainstream. And as that’s been happening, we’ve seen a pretty steady increase in correlations.

International-Stock Correlations Have Shifted Toward US Stocks

Hampton: Let’s turn to international stocks. Why has their correlation shifted more toward US stocks?

Arnott: You would think that international stocks might not move in exactly the same way as the US, and that was definitely true if you go back several decades ago, and reasons for that are they’re exposed to different local market conditions, currency movements from their home country, different demand patterns, and things like that. But as the economy is globalized, it’s much easier for capital to flow across borders, and most larger companies now have revenue not just from their local country but from many different countries across the world. So, that is one thing that has led to the increase in correlations.

I think another factor has been some of the big market shocks that we’ve had, so things like the global financial crisis in 2008 and the pandemic-driven market downturn in early 2020. Those were both global market events when markets around the world dropped at the same time and then proceeded to rebound basically at the same time also, so that has led to an increase in correlations.

Should You Have International Stocks in Your Portfolio?

Hampton: Amy, is there still a case to have international stocks in the portfolio?

Arnott: I think there is. One reason would be if you look at the global market, international stocks make up about 40% of the total market cap, so if you only invest in US stocks, you’re kind of leaving out a big part of the global opportunity set. Another argument for investing in international stocks is that the valuations are a bit lower. So, our equity analysts have found their price/fair value estimates for non-US stocks are lower than for US stocks overall. International stocks can also be a good way of diversifying sector exposure. Since technology stocks have been leading the US market for so long, they now make up about 30% of the overall equity market. But if you diversify into international stocks, you would get more exposure to old economy sectors, so things like industrials, financials, and utilities, which could offset some of that growth and tech stock exposure.

And then the other major reason for investing in non-US stocks would be to diversify your currency exposure. The dollar has been very strong for the past several years, but if eventually that trend reverses, having exposure to other currencies could be beneficial.

How Have Commodities Performed?

Hampton: Well, that is a case for international stocks. Commodities like gold and energy historically have had lower correlations with other asset classes. How have they performed over the last few years?

Arnott: Gold has done quite well, it held up really well during the pandemic and has done pretty well ever since then. Gold typically does well as a safe haven during periods of market uncertainty or global geopolitical uncertainty. I would say energy has had more of a mixed performance. Oil, for example, did very well in 2021 and 2022, had more of a mixed performance in 2023 when the price of crude oil was bouncing around during the year, but ended the year a bit lower. And natural gas, we saw sort of a supply glut combined with weak demand because of the mild winter. Performance was more mixed on the energy side.

What Hurdles Could Commodities Face?

Hampton: And commodities can help hedge against inflation. What could complicate that relationship in the future?

Arnott: One thing is that commodity performance is very commodity-specific. So, commodity prices, since they’re not generating cash flows, so the prices are basically determined by supply and demand. So, anytime you have a change either on the supply side or the demand side for a specific commodity, you can have pretty major price swings. I think another major factor would be some political and regulatory risk, especially around things like environmental concerns. So, obviously, there’s a lot of political pressure to shift away from fossil fuels, and a lot of politicians oppose mining, and things like that, which could also be a headwind for commodities.

Cryptocurrency’s Correlation Trend and Role in Your Portfolio

Hampton: And you mentioned cryptocurrency earlier. What’s been its correlation trend and where does it fit in a portfolio?

Arnott: Cryptocurrency, these are digital assets, so they are very different from any other type of traditional asset, like a stock or a bond. And historically, cryptocurrency has had very low or even negative correlations with most other asset classes. But we have seen those correlations steadily increasing over recent years as institutional investors have been adopting crypto, and we have a bunch of spot bitcoin ETFs that were approved. So, as crypto has moved more into the mainstream, correlations have increased.

Another thing I would point out is that even though crypto has generally had pretty low correlations, the correlation does tend to spike during market drawdowns. So, you’re not really getting diversification value when you need it the most, which is when the market is down. So, because of that, I would look to crypto as more of a speculative asset, and you definitely want to keep it to a very small percentage of your portfolio if you own any at all.

What Investors Need to Know About Private-Market Investing

Hampton: We’ve talked about publicly-traded investments, your team also looked at private-market investing. What should investors know?

Arnott: Private-market investing encompasses a wide range of securities that aren’t available to the general public. So, things like private equity, venture capital, private credit, private real estate. And because these types of assets aren’t traded as frequently, they can offer some diversification benefits. But I would also point out they are also a lot less liquid than traditional asset types. And because the pricing is much less frequent, sometimes they can be subject to dramatic price resets, which can increase the risk. So, even though there’s sort of a theoretical diversification benefit, at the end of the day, you’re still investing in stocks and bonds. It’s just in a slightly different format.

REITs vs. Overall US Market

Hampton: Did any of the asset classes’ performances surprise you?

Arnott: I think the biggest surprise for me has been real estate and just how much we’ve seen correlations increase. I think over the past three years, if you look at correlations for a REIT index versus the overall US market, it’s about 0.9. So, a lot of financial advisors and individual investors will advocate carving out part of your portfolio for real estate or REITs, specifically, because of the higher yield and the potential diversification benefits, but at least in recent years, we really haven’t seen that benefit from diversification.

Best Diversifiers for Investors to Add to Their Portfolio

Hampton: If someone wants to add diversifiers to their portfolio, what would you recommend?

Arnott: I think bonds would be probably the best place to start, just to make sure that at an overall asset-class level, you have some exposure to both stocks and bonds. Treasury bonds and cash are probably going to be the strongest diversifiers.

I think a couple of other areas that are worth considering for diversification would be commodities for a small percentage of your portfolio and potentially gold, as well as international stocks. We talked about the fact that correlations for international stocks have been trending up. But especially if you look at emerging markets, the correlations are much lower. So, I think there is a case to be made for having some broad international exposure, including emerging markets as part of a diversified portfolio.

Hampton: Well, Amy, thank you for coming to the table and sharing your research about portfolio diversification.

Arnott: Great. Thanks for having me.

Hampton: That wraps up this week’s episode. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to senior video producer Jake VanKersen and associate multimedia editor Jessica Bebel. And thank you for watching Investing Insights. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.