In a recent article we discussed strategic and tactical asset allocation and its benefits. For this article we explore the value of asset class diversification which traditionally rests on low return correlation and improved risk-adjusted returns via multi-asset strategies.
The starting point
The academic consensus strongly supports the case for asset allocation. One of the most acclaimed studies – conducted by Brinson, Hood, and Beebower (1986) – concluded that ~90 per cent of a portfolio’s long-term return variation could be explained by striking the right balance between risk and potential return through dividing an investment portfolio into different asset classes.
Crucially, as long as the returns of any two assets are not perfectly positively correlated, i.e correlation coefficient of +1, combining them offers significant diversification benefits by helping to reduce overall portfolio volatility and improve risk-adjusted returns.
The theory…
What is an asset class?
An asset class (e.g., equities, bonds, cash, property) is a set of investments with similar economic drivers and risk/return characteristics. Because exposures are aligned to the same macro factors, returns within a class tend to be highly correlated over time.
Why combine asset classes?
Allocating your investments across multiple asset classes adds diversification by mixing different return drivers (growth, income, inflation sensitivity, duration, credit). The aim is to improve the portfolio’s risk-adjusted return—reducing volatility and drawdowns for a given return target.
A practical caveat
In periods of market stress, cross-asset correlations can rise materially. Rapid policy shifts or a dominant macro theme (e.g., persistent inflation) can push equities, corporate credit and some alternatives to move together, diminishing diversification benefits temporarily. Designing portfolios with this in mind (e.g., including true diversifiers, liquidity buffers, and rebalancing rules) helps maintain resilience.
Where to from here
Despite the dent to bonds’ reputation as a hedge since 2022, we still back diversification across asset classes. Several evolving risks argue for a balanced mix and for bonds to resume their role as a stabiliser:
• Bond–equity correlation turning negative again: As the earlier positive relationship fades, high-quality bonds should recover their downside-hedge characteristics, especially with growth slowing and risk premia tight.
• Labour market risk: Any weakening in employment would pressure corporate profits and increase equity volatility.
• Policy and geopolitics: Tariff uncertainty and broader tensions raise the chance of demand shocks and risk-off episodes.
So, our approach to markets in 2026 is as follows:
• Core defensive anchor: Maintain exposure to high-quality duration (govt/IG bonds) as the primary shock absorber; avoid over-extending term if inflation proves sticky.
• Selective growth: Keep equity risk but tilt toward emerging markets (valuation/currency tailwinds) and small caps (operating-leverage to recovery), sized within risk limits.
• Real-asset ballast: Use commodities (incl. gold, silver) for inflation/risk hedging; prefer diversified exposure (gold + copper via quality miners/ETFs).
• Liquidity & rebalance: Hold a cash buffer to fund rebalancing on drawdowns; keep rules-based rebalancing to harvest volatility.
• Quality bias: In credit and equities, prioritise strong balance sheets and resilient cash flows.
Bottom line: With growth cooling and shocks possible, we favour balanced risk: bonds back as a hedge, equity exposure kept but tilted to emerging markets and small caps, and commodities as a diversifier—implemented with clear guardrails on duration, credit quality and liquidity. Meanwhile, a rate-easing cycle provides a strong tailwind for REITs.
Chris Harris is an Authorised Representative (no 427052) of Ord Minnett Ltd ABN 86 002 733 048, AFS licence 237121. This article does not contain legal advice, and only contains general financial advice. Your personal circumstances has not been considered; you should determine its suitability to you. Before acquiring a financial product you should consider the relevant product disclosure statement. Past performance is not a reliable indicator of future performance. Chris can be reached on 07-5231-9966.
