How to diversify AI exposure and align portfolios with risk tolerance

Investing.com - Investors should take caution before abandoning bonds in favor of chasing gains in artificial intelligence-exposed technology stocks, according to analysts at Wells Fargo.

Using fixed income has long been seen as a tactic to diversify equity risk in portfolios, although a "structural shift in correlation" between bonds and stocks in 2022 raised concerns over the efficacy of this tactic, the analysts including Veronica Willis said in a note to clients.

In that year, bonds -- which, given their status as a possible risk hedge, have traditionally been assumed to move in opposing directions to equities -- sold off during a stock market downturn.

The long-term correlation between equity and fixed income has since shifted higher, meaning that there have been more instances of stock and bond prices moving in the same direction than in the past, the analysts wrote.

The subsequent worries over fixed income’s role as a portfolio diversifier have further intensified during a multi-year boom in enthusiasm for AI. Heavy expenditures and hopes for massive productivity gains have helped to underpin a surge in stocks to new record highs.

Equities have subsequently outpaced fixed income, with allocations likely drifting into sectors like information technology, communication services and mega-cap tech names as part of a bid to keep up with the AI-driven rally, the analysts said.

Still, they warned against completely leaving behind "fixed income and other diversifiers to chase performance," even as the AI theme has dominated markets.

"We encourage investors to not only diversify their allocations to maintain the appropriate risk-and-return balance for their risk tolerance and investment objective, but to diversify their AI exposure outside of the U.S. technology space into other equity sectors and asset classes, and even into other asset groups," the analysts wrote.

Looking outside of public markets, the strategists said they favor "event driven" strategies, such as merger arbitrage, which can "capitalize on increased" deal activity in technology. Private equity, private debt, and private infrastructure also provide avenues to target growth in AI-related businesses, including exposure to non-public firms building out data centers and laying the groundwork for AI adoption, they added.

Commodities offer another way to diversify, while helping reduce volatility and mitigate downside risk in portfolios, they argued.