Near Zero Interest Rates & Diversification

There is an interesting relationship between the “risk-free” rate (t-bill rate) and the benefits of diversification. When rates are close to zero, the risk reduction benefits from low or anti-correlated assets can offset the requirement for those assets to have a sufficient expected return to make diversification practical for enhancing risk adjusted returns.

This extends to all assets– including those that do not have a theoretical risk premium such as certain commodities and currencies. Conversely when the risk-free rate is high, it is nearly impossible to justify diversification with the exception of those assets that can be assured of producing a risk premium. In this case, only stocks, bonds and real estate would qualify as assets that should produce a return in excess of the risk-free rate since their pricing is inherently tied to the cost of borrowing/lending.

It is conventional wisdom that gold  should not have a risk premium, and historically this has been true though this is a separate debate. What is more important is that gold carries a negative correlation to other assets, and thus in a low or zero interest rate environment it does not need to have much of an expected return in order to improve portfolio risk-adjusted returns. Consider that holding standard deviation constant,  an asset with a -.5 correlation reduces portfolio risk by 50%.

That means that gold returns can be up to 50% lower than all other asset returns and still improve the portfolio sharpe.  The same principle holds true for all assets that have low or negative correlations to equities.  This  substantially increases the pool of assets that would qualify for inclusion in a properly diversified portfolio. The lower the correlation, and the lower the expected return of equities, the lower the expected return hurdle for assets without risk premiums need to be to improve risk-adjusted performance.

This means that expected returns that are zero or even negative can potentially qualify such assets for an efficient portfolio.  Of course, this is a “special situation” that occurs in the rare circumstances where interest rates are near zero. Thus the conventional approach of focusing only on assets that have a risk premium in all environments is a flawed approach. A superior approach would consider the dynamics of interest rates and all asset correlations along with a possible range of expected returns.