Why you need marketplace lending to diversify your asset classes

The most important rule for investors is diversification. Spreading your savings across a wide group of holdings mitigates risk. Traditionally, investors commit to the popular blend of 60% stocks and 40% bonds. Many believe this simple approach satisfies the goal of diversification. While such a portfolio contains many different companies the strategy is flawed because only two asset classes are in play. In this post we’ll take a look at the two reasons why stock and bond diversification is insufficient for building long-term wealth.

Domestic and International Equity Correlations Are Rising

The idea behind diversification is simple. Holding a broad group of stocks means an investor can weather downturns isolated to a few companies. The misfortune of one stock in a portfolio may be the windfall of another. This phenomenon creates balance over the long-term. However, in recent years, this inverse relationship has faltered. “Since the post-financial crisis market bottom in 2009, the rally in equities has been extremely broad. Not only is every S&P 500 sector up since that point, but so are 96% of the S&P 500 components,” remarks a reporter for MarketWatch. For the moment this is good news for investors. However, the reverse side to the coin will be equally powerful when stocks inevitably decline; the effect will be across all equities.

One way to combat this problem is with exposure to both domestic and international stocks. Unfortunately, rising correlations are a problem here as well. Research from BlackRock shows that between 1980 and 1989 the correlation between U.S. and international equities was just 0.47. Between 2010 and 2015 this figure grew to 0.88. This trend undermines the purpose of diversification. There are many reasons for this development. Our global economy has become increasingly interconnected as trade increases between countries. Additionally, technology has enabled more cross border engagement which builds more symbiotic relationships. Simply put: domestic/international diversification isn’t as effective as it used to be.

Stock and Bond Correlations Are Rising

One Morgan Stanley Investment Management portfolio manager recently remarked, “There’s no getting around the fact that when assets are highly correlated it’s difficult to construct a diversified portfolio.” Unfortunately, this is exactly what is happening in today’s market. As bonds rise and fall in lockstep with stocks, investors are not getting the diversification they need. More troubling are the lower returns. That is, bonds offer a lower return than stocks because of their lower risk profile. However, as correlations rise between stocks and bonds this risk/return trade off becomes less attractive.

Why has this trend emerged? “Historically, the value of a fixed- income asset was mainly driven by economic fundamentals, with a smaller component coming from other kinds of risks. Today, the opposite is true,” lamented the portfolio manager. The ultimate result is that market volatility has a greater impact on investors. Losses are compounded. In mid 2016 Morgan Stanley Research reported that the previous 12 month correlation between stocks and bonds increased 22%.

The Solution: Asset Allocation

With correlations rising investors need to be more cognizant of diversifying across a greater number of asset classes. Relying on stocks and bonds is not enough.

Consider research from Vanguard citing “From 1988 through 2007…a portfolio allocated 50% to U.S. stocks and 50% to U.S. bonds would have averaged a 9.9% annual return with a standard deviation of 7.4%.

How does this compare with a more diverse array of assets? “A portfolio equally weighted among the six categories of assets…in addition to U.S. stocks and U.S. bonds (12.5% allocated to each) would have averaged a 10.9% annual return with a standard deviation of 7.6%.” This comparison illustrates how numerous asset classes can deliver a higher return for nearly the same risk.

Other asset class include commodities, real estate, emerging market funds and of course marketplace lending. Investing with Bondora’s P2P investment platform does carry some risk. However, this risk is different than those inherent in stocks and bonds. Moreover 89% of Bondora investors earn over 10% annually. This is extremely competitive with the 5.4% inflation-adjusted annualized returns (1900-2011) of stocks according to Credit Suisse.

Boost the diversification and return of your portfolio with the growing business of P2P lending.