Principles For Building A Resilient Portfolio
- Patrick Ling
- Feb 24
- 5 min read
Inflation poses a significant threat to long-term wealth preservation, making investing a necessity rather than an option. However, investing is not like exercising—where consistency alone delivers results. In financial markets, simply dedicating time and effort does not guarantee success. Markets are inherently unpredictable, and unforeseen crises can rapidly erode portfolio value.
Creating a robust portfolio capable of enduring different economic scenarios is essential. Although completely eradicating risk is not feasible, certain market principles can strengthen portfolio resilience throughout market cycles. Here are some of these fundamental market principles.
1. Liquidity: The Lifeblood of Markets
Liquidity is the driving force behind stock market performance. It is shaped by multiple factors, including interest rates, the availability of public and private credit, and leverage across both corporate and financial sectors. While liquidity is challenging to quantify precisely, the Chicago Fed’s National Financial Conditions Index (NFCI) provides a useful gauge.
A reading below zero indicates loose financial conditions, supporting asset price appreciation.
A reading above zero signifies tight financial conditions, which historically correspond to lower market returns.
Historical data reinforces this relationship:
From 1971 to 1990, a period of predominantly tight financial conditions, the S&P 500 delivered 6.63% annualized returns.
Between 1991 and 2007, during looser financial conditions, returns improved to 9.17%.
When factoring in the 2008 Global Financial Crisis (GFC), returns from 1991 to 2008 drop to 5.75%, aligning more closely with the earlier period of tight conditions.
Post-GFC (2009–present), amid sustained ultra-loose conditions, the S&P 500 has delivered an impressive 12.64% annualized return.
Key Takeaways:
Liquidity influences market performance as much as fundamentals. Overvalued markets can still rise if liquidity remains abundant.
Liquidity is not a substitute for strong fundamentals. Excess liquidity can fuel market bubbles, but it can be withdrawn swiftly—either by central banks tightening policy or by the market itself imposing discipline.
2. Diversification Beyond Equities
The global financial system is multi-asset in nature, with stocks representing just one segment. The largest asset class is fixed income (bonds), alongside real estate, private credit and equity, commodities, and foreign currencies.
Liquidity does not always flow into equities, even in loose financial conditions. This variability in capital allocation explains why stock returns remain unpredictable despite favorable financial conditions.
The chart above shows the rolling 1-year return of the S&P 500 as represented by the SPDR S&P 500 ETF Trust (SPY). This variability in rolling 1-year return is also applicable to other asset classes as shown below.
Key Takeaway:
An immediate observation is that the different asset classes move to their own beat. When one asset class return is weak, others might be strong. Liquidity often moves from one asset class to another and back again some time later. The applicable lesson here is that a well-diversified portfolio—allocated across multiple asset classes with dynamic position sizing—can enhance risk-adjusted returns and reduce volatility.
3. Accounting for Second-Order Effects
Financial markets rarely behave in a linear fashion. Policies and macroeconomic events often trigger second-order effects—unexpected consequences that can counteract initial expectations.
Consider the Federal Reserve’s 50bps rate cut in September last year:
Leading up to the announcement, the market expected rate cuts, driving the U.S. 10-year yield lower.
However, immediately after the announcement, yields unexpectedly surged, exceeding pre-cut levels.
Why did yields rise?
The rate cut fuelled concerns that inflation could reaccelerate, leading to higher inflation expectations and rising commodity prices.
Inflation did come back as commodity prices started rising strongly after the jumbo rate cut.
Key Takeaway:
Over-reliance on first-order thinking can lead to misjudged asset allocation and overconfidence in positioning. A robust investment strategy must account for potential second-order effects.
4. Market Expectations vs. Positioning
Market reactions to macroeconomic events can vary significantly over time. For instance, a high unemployment rate might trigger a market sell-off in one scenario but drive equities higher in another.
This inconsistency stems from market positioning. Asset prices respond not just to new information but to how that information differs from existing market expectations. If an event is already priced in, it may have little or no impact on asset prices.
Key Takeaway:
Avoid reacting impulsively to news headlines. Markets often experience short-term price fluctuations that later correct themselves.
5. The Importance of Hedging
Not all adverse market events trigger severe downturns. The extent of the reaction depends on how well market participants are hedged.
Institutional investors and leveraged market participants routinely hedge portfolios using derivative instruments, particularly put options on major indices (e.g., S&P 500).
If market participants are adequately hedged, a negative event will likely be absorbed without significant disruption.
If portfolios are unprotected, widespread panic hedging or liquidation can trigger a sharp market decline.
A useful indicator of market complacency is the cost of put options—when they are unusually cheap, it suggests investors may be underestimating risk.
Key Takeaway:
Understanding market positioning through derivatives pricing can provide valuable insights into potential vulnerabilities and opportunities.
6. When Cash Becomes King
Liquidity crises can result in broad-based declines across all asset classes, as seen in 2022 when the Federal Reserve aggressively raised interest rates to combat inflation.
During such periods, cash becomes a valuable defensive asset. This is particularly true when:
Liquidity is draining from multiple asset classes.
Short-term interest rates offer attractive yields.
Key Takeaway:
Holding cash during liquidity-driven downturns can protect capital and provide dry powder for future opportunities.
Applying the Principles
These principles can be systematically applied through:
Dynamic asset allocation that adjusts exposures as markets evolve.
Volatility trading that capitalizes on dislocations in derivatives markets.
These principles can also serve as a broader guide for investors seeking to navigate financial markets with discipline, adaptability, and risk-awareness.
By incorporating these principles, investors can construct resilient portfolios capable of withstanding market uncertainties while optimizing returns over the long term.
Disclaimer:
The information provided in this blog post is for educational and informational purposes only and should not be construed as financial or investment advice. The strategies and examples discussed are based on past market conditions and may not be suitable for all investors. In preparing this note or post, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. While the information provided herein is believed to be reliable, AllQuant makes no representation or warranty whether expressed or implied, and accepts no responsibility for its completeness, accuracy, or reliability. Investing involves risks, including the potential loss of principal. The performance of any investment strategy is not guaranteed, and past performance is not indicative of future results. Always consult with a qualified financial advisor or professional before making any investment decisions. AllQuant is not responsible for any financial losses that may arise from the implementation of strategies or ideas discussed in this post.
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