What The Risk-On, Risk-Off Trade Means for Investors

Correlations among asset classes, which soared during and after the financial crisis, have jumped again recently. It’s part of the “risk-on, risk-off” trade many have cited — when investors have been feeling better about the global economy, they have embraced risk just about anywhere they can find it; when fears rise, they shun risk, regardless of the asset.

According to Wells Capital Management’s James Paulsen, that’s creating a myriad of opportunities that many investors will regret not having taken advantage of.

Paulsen tells The New York Times that the risk-on, risk-off trade is a result of investors still coping with the “total obliteration of economic confidence in this country and in the world during the financial crisis.” But, he says the economic recovery is well underway, and risk is actually low right now. “People are already pricing things for a potential depression, so there’s a tremendous amount of protection in prices, and a tremendous upside,” he said. “The dysfunction in the market — the high correlations — all of that is offering investors an opportunity rather than something to avoid. Eventually this will all go away and that will be kind of sad, because it will mean these opportunities will be over.”

The Times’ Jeff Sommer also discusses some of the implications of the risk-on, risk-off phenomenon, in particular the impact it has on diversification. If asset classes are moving together, investors may not be as diversified as they think, HSBC strategist Stacy Williams tells him. And, author and Cornell economics professor Eswar Prasad notes that, while developing market economies have grown more independent, their stock markets have been quite synchronized with markets in developed countries, which also has implications for diversification strategies.

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