The phrase "markets can fall as well as rise," is a familiar enough one to investors, but how often do we really think about the downside? While most investors are happy enough to see their stocks go up and up, no one can predict for sure how far an individual stock will rise or, perhaps more importantly, how far it will fall.
Many investors try to cancel out the risk that they have picked a bad stock by buying a number of different stocks, adding bonds to the portfolio or buying stocks of companies in different countries around the world. Investment professionals call this process diversification and it is traditionally regarded as the best way to ensure that, overall, a portfolio will generate a positive return.
There is some evidence, however, that even if an investor diversifies a traditional portfolio of stocks and bonds internationally, it will not be enough to prevent an overall fall in value in a bear market.
One of the main reasons for this lies in the globalisation of the world economy. Governments and companies are increasingly working to a global agenda — so that securities listed on different international markets are responding to similar fundamentals. Meanwhile, individual investors are acting on information that is disseminated around the world in seconds.
What this means is that a fall in one market is more likely to trigger a similar reaction in markets around the world. This risk is particularly acute when investor sentiment suggests that one or more of the main markets is overvalued. The threat then is of a general bear market, or worse still, a global recession.
As investors have become more concerned about these global factors, interest in alternative investment strategies has increased. What investors are seeking are investment strategies that respond differently to market factors from an ordinary investment in stocks and bonds. In investment terms, these are called non-correlated asset classes.