Future Focus: Where do you go when everything is expensive?
Experts weigh in on why you need to diversify differently now.
For much of the last decade, investing has felt relatively straightforward. Equity markets delivered strong returns and diversification wasn’t a difficult task. Investors are now operating in a very different environment.
Over this period returns outstripped earnings growth and equity valuations are elevated across many developed markets, particularly in the US, where optimism around AI, productivity and earnings resilience has pushed multiples well above long-term averages. At the same time, credit spreads remain compressed and are near historically tight levels in parts of the US market. This raises an uncomfortable question for investors - are we still being adequately compensated for taking risk?
It’s not just traditional risk assets’ that appear expensive. Assets that investors have historically turned to for diversification and protection - including gold - are also trading at elevated levels.
The macro environment is also looking uncertain. Treasurer Dr Jim Chalmers believes that we’re likely to face sustained inflation in the 5’s. The Iran War’s flow on effects have caused tighter budgets for consumers. Investors are left facing a difficult challenge: if equities are expensive, credit is expensive, and even diversifiers are expensive…where do you go?
Yet many market commentators remain optimistic. They argue that just because everything looks expensive doesn’t mean asset classes are actually expensive. Are we simply investing in a different regime - one where structurally higher valuations, persistent inflation, and lower forward returns become the new normal?
I had the pleasure of moderating a panel of multi-asset investment professionals and asked this question. One of the recurring themes from the experts was the need for investors to rethink how they diversify.
I’ve shared some valuable insights from the discussion and my own thoughts after listening to the panellists.
A nuanced view of valuations
Valuation levels were a recurring theme throughout the discussion. There were several themes in the commentary from the panellists.
What does expensive mean?
An important distinction the panellists raised was that expensive does not mean ‘about to crash’.
Markets can remain expensive for long periods. Valuations are useful indicators of future return expectations, but they are notoriously poor timing tools.
This distinction matters because many investors hear ‘overvalued’ and immediately think that assets should be avoided, or they should move to cash. The reality is more nuanced.
Today’s environment is unusual because high valuations are appearing across multiple asset classes at once.
The valuation dilemma facing investors
One of the clearest themes from the discussion was the tension investors face between elevated valuations and the need to stay invested.
Across global equities, valuations remain stretched relative to historical averages, with the US market doing much of the heavy lifting. Bryce Anderson from Morningstar noted that while many US companies are unquestionably exceptional businesses, the real question is whether current prices already assume years of future growth.
Sebastian Mullins from Schroders added that at a sector level, the game has changed. Communications sectors used to be telephone companies. Now, it is companies like Meta and Alphabet. Relative valuations are not comparing apples to apples.
This distinction between a ‘great business’ and a ‘great investment’ became a recurring theme throughout the session.
Australian equities face a similar challenge. Valuations appear elevated, but the market is also heavily concentrated. With companies like Commonwealth Bank and BHP representing a significant share of the index, investors need to think carefully about what risks they are implicitly taking through passive exposure.
The panel stressed that valuations matter because they shape future return expectations. However, valuations are not a useful short-term timing tool. Expensive markets can remain expensive for years.
Opportunities beneath the surface
Despite concerns around expensive markets, the conversation also highlighted that opportunities that still exist beneath the headline numbers.
In listed property and infrastructure, the panel noted a clear divide between sectors benefiting from the artificial intelligence buildout and those that are not. Assets tied to data centres and AI-related infrastructure have become expensive, with muted forward return expectations.
The same ‘haves and have nots’ dynamic was discussed in global infrastructure markets.
Opportunities are often found in areas where expectations are already extremely low. Bryce Anderson notes that when Morningstar looks for investments, they do not necessarily need to move from ‘good to great’ to generate strong returns. Sometimes moving from ‘terrible to less bad’ is enough.
Diversification in the current environment
The changing relationship between stocks and bonds
For decades, bonds were the classic portfolio diversifier. They provided two things simultaneously: portfolio defence and diversification benefits through their negative correlation with equities
When equities sold off, bonds often rallied. That negative correlation became one of the foundations of diversified portfolio construction. The inflation shock of recent years challenged that assumption.
In 2022, both equities and bonds fell sharply together as rising inflation and interest rates hit most financial assets simultaneously. Investors who thought they were diversified suddenly discovered that many parts of their portfolio were reacting to the same macroeconomic force.
Source: Future Standard
That doesn’t mean bonds no longer have a role. Higher yields today arguably make bonds more attractive than they were several years ago. However, it does mean investors can no longer assume that diversification automatically works in every environment.
This is particularly important for investors that are about to achieve their portfolio goal, or investors that are drawing down on their portfolios.
In periods driven by supply shocks and persistent inflation, bonds may not provide the same level of protection they historically delivered during growth slowdowns or demand shocks. In a high inflation regime, assets such as commodities, infrastructure, inflation-linked bonds and certain property sectors may play a larger defensive role than they have historically.
Diversification now requires more precision
One of the more interesting themes from the discussion was the idea that investors may need to diversify more intentionally rather than more mechanically. By that, it means actually thinking about how the allocations in your portfolio interact with each other. Understand:
- The risk you are trying to hedge
- The economic environment that would hurt the chances of you achieving your goals
- Which assets behave differently
- Reflecting on whether you are making purposeful decisions for your portfolio, or whether you are just adding complexity.
This is particularly important in an environment of structurally higher inflation and potentially higher volatility.
In the past, investors often diversified primarily against recession risk. Today, investors may also need to think about inflation risk, geopolitical risk and policy uncertainty in a way they haven’t for decades.
We’re seeing that the traditional ‘safe’ assets may not always provide protection against those risks.
Another key point from the panel was that diversification at any cost can become expensive and ineffective. There has been a rising trend in the adoption of alternative assets, private markets or thematic exposures – adding layers to portfolios.
Diversification should not simply be about owning more things. It should be about owning assets that behave differently under different economic conditions. That sounds obvious, but in practice, many portfolios end up concentrated in the same underling risks. I’ve written about this risk in Australian investors’ portfolios, and in passive portfolios. We’re doubling down on the same concentration, and the same macroeconomic drivers.
Investors have been adopting these assets in the name of diversification, but more holdings do not automatically improve a portfolio. There are many factors to consider, including correlation, liquidity, cost and fees.
What matters significantly through volatility and tight markets is behavioural compatibility with holdings. The best portfolio on paper is useless if investors cannot stick with it through volatility.
One of the recurring themes from the conference was that behaviour may become an even larger driver of outcomes in a lower-return world. If future returns are more muted, avoiding major mistakes becomes increasingly important.
My view
The challenge for professional investors is that there are fewer obvious pockets of cheap assets to rotate into. The difference between professional and individual investors is that constantly rotating a portfolio is not necessary for many individuals.
We have no reason to rotate unless the securities in our portfolio no longer serve the purpose they are supposed to. The definition of ‘expensive’ depends heavily on the investor’s objectives and time horizon.
For investors with decades ahead of them, elevated valuations may matter less because compounding remains the dominant driver of outcomes over long periods. Retirement portfolios face a different challenge. Investors drawing income from their portfolio may prioritise stability, income generation and downside protection over maximising long-term growth.
This means the same asset can look attractive in one portfolio and expensive in another. Investors cannot assess valuations in isolation. Asset allocation decisions should always be linked back to the purpose the portfolio is trying to serve.
This distinction between individual and professional investors was discussed with multiple panellists pointing out that professional investors have very specific goals that differ from most individual investors. Sebastian Mullins acknowledged that even though this was his approach, he is dealing with short time horizons and focused on minimising drawdowns and smoothing the return profile out.
This context is important for individual investors who may lean on professional investors for portfolio decisions and opportunities. These holdings are chosen with a much different context in mind to most individual investors’ goals.
Doing nothing is sometimes the right decision
One of the more reassuring insights from the panel which aligned with my own view of markets was that sometimes the most rational portfolio decision is to do very little.
When markets feel expensive and uncertain, the temptation to constantly reposition portfolios. Investors want action. Movement feels productive. This is action bias. Reacting to headlines often creates more damage than the market environment itself.
Part of this is a mindset shift. A diversified portfolio is not designed to maximise returns in every market environment. It is designed to create a portfolio investors can survive across many different environments while achieving a set of goals. That means some parts of the portfolio will almost always feel disappointing at any given moment.
The uncomfortable reality is that effective diversification often feels inefficient while markets are rising strongly. But its value typically only becomes obvious during periods of stress.
Final thoughts
The real challenge for investors now is not simply finding the next outperforming asset class. It is building portfolios that remain resilient in a world where valuations are higher, returns may be lower, inflation is more volatile and correlations may behave differently.
Underpinning all of this is that uncertainty is likely to remain elevated. This required a resilient portfolio and a resilient mindset.
The portfolio that will perform the best over the next decade may not be the one with the most aggressive positioning. It may be the one that investors are actually able to hold onto.
This article draws on the insights from a session at Morningstar Investment Conference: High prices, hard choices: where to invest when nothing is easy. The panel consisted of Shani Jayamanne (Moderator, Morningstar), Bryce Anderson (Senior Portfolio Manager, Morningstar), Sebastian Mullins (Head of Multi-Asset & Fixed Income, Schroders Australia) and Daniel Stojanovski (Chief Investment Officer, Ventura Funds Management).
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