Navigating 2025: Why investors need to diversify and hedge their portfolios
Goldman Sachs Exchanges
Deep Dive
What were the key drivers of portfolio performance in 2024?
Long risk strategies worked well in 2024, driven by outperformance in U.S. and global economies. U.S. large caps outperformed small caps by 12.5%, and Europe underperformed the U.S. significantly. Credit markets, especially in the U.S., had a strong year with IG spreads tightening by 25 basis points. The yen underperformed, while the U.S. dollar outperformed due to yield differentials and political factors. U.S. interest rates saw yields back up by 100 basis points since September.
Why is the macro backdrop expected to shift in 2025?
The macro backdrop in 2025 is expected to shift from an 'inverse Goldilocks' scenario, where inflation fell without growth declining, to a more reflationary environment. Growth remains healthy, but inflation is unlikely to decline as much, leading to potentially lower Sharpe ratios, less risk premium compression, and less valuation expansion. This shift could result in narrower performance and less carry-friendly conditions.
What are the key allocation strategies for 2025?
In 2025, investors should focus on diversification across and within asset classes. Overweighting equities remains favorable, but with a focus on relative value in rates across regions like the U.K. and China. Alternatives, such as hedge funds and private markets, are recommended for diversification. Bonds are expected to contribute more to risk reduction in multi-asset portfolios, and investors should avoid overconcentration in momentum stocks like the Magnificent Seven.
Why is diversification critical in 2025 given market concentration risks?
Diversification is critical in 2025 due to extreme market concentration risks. The top 20 stocks in the S&P 500 drive over 50% of its volatility, and the Magnificent Seven have seen significant valuation expansion. These stocks are now overvalued relative to structural fair value models, and their high volatility contribution increases portfolio risk. Diversifying internationally and into laggards, such as emerging markets, can mitigate these risks.
What are the risks to the 2025 investment outlook?
Key risks include potential disappointment in the profitability of the Magnificent Seven, stickier inflation, and geopolitical uncertainties. Inflation risk premiums are currently low, and any reacceleration could disrupt markets. Additionally, trade policy uncertainty and central bank communication errors could lead to volatility. The bond market faces supply-demand imbalances, with significant issuance potentially causing indigestion and impacting term premiums.
What hedging strategies are recommended for 2025?
Hedging strategies for 2025 include diversifying into alternatives like gold, which benefits from strong central bank demand, and safe-haven currencies like the U.S. dollar. Equity put options are recommended, especially around key events like the U.S. inauguration and earnings season, due to concerns about corporate profitability and ROE. Credit spreads are tight, and implied volatility in credit is low, making options relatively cheap for hedging purposes.