Balancing the Risks to Portfolios from an Innovation Boom and Inflation

Investment portfolios face two key challenges: With the boom in capital expenditures on artificial intelligence (AI), there is a growing risk that tech stock profitability slips before the benefits of the new technology start to kick in. At the same time, inflation volatility and fiscal risks have risen, meaning bonds may provide less of a buffer for investors, according to Goldman Sachs Research.

“For most investors, portfolios in the last year or two have been driven by these twin forces of innovation and inflation,” says Christian Mueller-Glissmann, head of Asset Allocation in Goldman Sachs Research. “There are risks related to both of those.”

What are the biggest risks to investment portfolios?
 

Inflation has flared up more frequently in recent years, and a standard portfolio may not be well prepared for that volatility, Mueller-Glissmann says. AI innovation has accelerated, adding to what amounts to a 15-year boom in which technology companies have led the US stock market. By extension, exposure to the equity market and technology stocks has increased in many portfolios, including the benchmark World Portfolio that often guides asset allocation. 

The average investor is increasingly “exposed to equities, more exposed to tech, and more exposed to specific stocks linked to innovation,” Mueller-Glissmann says.

While Goldman Sachs Research expects AI to produce a boost to earnings and productivity over time, there’s the potential that burgeoning investment results in overcapacity, making it difficult for companies to maintain profitability. There is uncertainty as to the time it will take for the benefits of AI adoption to show up in the economy and in corporate bottom lines.

“You had some incredibly successful companies that were launched around the time of the dotcom bubble,” Mueller-Glissmann says. “When the bubble burst, they had significant corrections because it took a long time for their business models to eventually show growth and show the market share gains that investors were hoping for.”

Should investors rebalance their portfolios when assets are rallying?
 

The challenge for investors is whether to sell some assets that have performed well and rebalance their portfolios—which risks missing out on an ongoing rally—or ride the momentum. 

“Rebalancing over the very long run has paid off, and you want to have a disciplined approach to portfolio construction,” Mueller-Glissmann says. “The problem is that when you are in these periods of incredibly strong equity returns, and when you're in these periods of tech leadership, it can be quite costly to lean against the momentum, especially if you're too early.”

How should investors diversify and rebalance their portfolios?
 

The portfolio strategies that Goldman Sachs Research suggests are not necessarily focused on market timing, but more on diversification and finding assets that are negatively correlated with technology stocks. Investors need to keep exposure to innovation, protect against inflation, and improve risk mitigation within portfolios, Mueller-Glissmann says:

Real assets (infrastructure, prime real estate, energy, or gold) help balance multi-asset portfolios against inflation risks, provide valuable diversification, and increase the potential for real, inflation-adjusted returns. Historically, Goldman Sachs Research’s equal-weight real asset index delivered positive returns and outperformed the broader market during major tech selloffs, such as the bursting of the dotcom bubble. 

“The best real assets are the ones where the structural supply-and-demand balance is predictable. That allows real cash flow growth to compound,” Mueller-Glissmann says.

Diversifying across investment styles within equities can help manage the risks linked to tech-stock momentum. Low volatility, high-dividend-yield stocks have outperformed during declines in the technology sector. Historically, there have also been large rotations from growth to value stocks during those periods.

Goldman Sachs Research expects investors to benefit from regional diversification and from managing risks linked to the US dollar and the dominance of US assets. Historically, US equities have underperformed during tech-led selloffs because US companies are more closely linked to innovation. A selloff in the US equity market, with non-US stocks outperforming, would likely be a catalyst for dollar depreciation.

In the event of recession, Japanese government bonds and those of emerging markets could provide more diversification within global multi-asset portfolios.

Options contracts can help hedge against stock market declines. Goldman Sachs Research finds that long-dated call options, which give investors the right to buy an asset at a certain price over a longer time period, were an effective risk-management strategy during the dotcom bubble. Convertible bonds, which can be converted into equity, have recently outperformed and can be a valuable instrument for portfolios late in the economic cycle.

Alternative assets, including private markets and hedge funds, can also improve risk-adjusted returns in later phases of a boom. “Especially when the return potential and diversification in traditional assets are more limited, alternatives can play a more important role,” Mueller-Glissmann says.

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