October 16, 2018
Alternative investments, or “alts”, can add diversification to your portfolio, which reduces your investment risk. They don’t have to be complex, though they certainly can be!
– Alternatives include any investments outside the traditional stocks, bonds, cash, and mutual funds. They include private equity, hedge funds, real estate, etc.
– They provide diversification since they do not perform the same way as the traditional asset classes do.
– Most individual investors can have 10-20% of their portfolio invested in alternatives.
– Real estate is a good alternative for many people. You can own actual property. Or, you can invest in Real Estate Investment Trusts (REITs), which act like mutual funds.
The traditional investing universe is comprised of stocks, bonds, cash, and the mutual funds that invest in them. Real estate and REITs (Real Estate Investment Trusts, which are basically mutual funds for real estate investing) are considered alternatives. Hedge funds, commodities, futures, and private equity funds are also examples of alternatives.
Given your risk tolerance, you can build an optimal portfolio providing the highest return using a mix of assets. Correlation is a measure of how strongly asset returns are related to each other. Noncorrelated assets create a more diversified portfolio, reducing risk. If one asset class isn’t performing well, a different one may be doing better. After a point, adding more assets doesn’t give you any more risk reduction.
Think about a one-asset portfolio. Let’s say the asset is Google stock. This is a very risky portfolio because if anything happens to Google, you could lose all your money.
Now add a second asset, such as Apple stock. A two asset portfolio is more diversified, because if something happens to Google specifically, the price of Apple may not change. However, Apple and Google are both large tech stocks. If one experiences a price decline, the other might as well. They’re highly correlated to each other.
Instead of adding Apple as a second stock, let’s add Ford instead. With this two-asset portfolio, if Google experiences a price decline, it’s less likely that Ford will too. They’re in different segments of the economy. Since both are large company stocks, they are still somewhat correlated. If investors stop buying large company stocks for some reason, they’ll both experience the decline.
We can diversify further. Investment grade bonds aren’t particularly correlated with any stock. Below investment grade, known as junk, bonds are correlated with the stock market.
Let’s add a bond in for a three asset portfolio. Now there’s a portion of the portfolio that doesn’t move in tandem with the stocks.
Even when the stock market declines, your bonds will keep you afloat. They don’t provide as much capital appreciation as stocks do, so the total return will not be as high as the two-stock portfolio. Bonds lower the investment risk, but with low interest rates don’t provide much return.
It’s a trade-off between risk and return. The more risk you can take, the lower your bond exposure, and the higher your return. But you’ll experience a lot of ups and downs in the portfolio as a consequence.
Having a mix of assets optimizes this risk/return tradeoff. Someone who is a conservative investor will have more bonds in their portfolio compared to a more aggressive one. Stocks need to be diversified as well. Small companies, mid-sized companies, and international ones are all somewhat uncorrelated with each other, and with large-cap stocks.
Adding in alternative investments to the mix, in addition to the stocks and/or bonds, further diversifies the portfolio and may increase the return as well. They’re not intended to replace stocks and bonds in the allocation, but to enhance it.
Allocations vary from investor to investor, of course. Shifting 5% of the portfolio to alts isn’t going to make much difference to the portfolio either way. You need at least 10%.
If you’re not as familiar with these investments, you can start by allocating 10%. Experienced investors might want to increase the percentage to around 20%. Institutional investors will often invest much more of their portfolios in alts. However, they have different investment goals and an infinite time horizon, which individuals don’t have.
You don’t need to sell off stocks or bonds to invest in alts. Use the cash you have, if any. If you’re making periodic deposits into your account, you can invest them in alts instead until you reach the allocation you want.
Real estate is an excellent alternative for many investors. Many people understand real estate basics, so the investment doesn’t have a significant learning curve. Some of the other alternative strategies are more complex, and their risk/return characteristics may not be as clear.
Real estate, in general, is uncorrelated with either stocks or bonds. Owning real property has historically been a wealth generator for Americans, though of course real estate values fluctuate just as stocks do.
REITs, in particular, make good diversifiers for a portfolio. They typically collect rent from the properties they own. They’re required to distribute 90% of their income back to shareholders. Many distribute all of it. Not only do shareholders earn income, but often the funds provide some capital appreciation as well.
In other words, REITs provide income, some capital appreciation, and uncorrelated performance. They’re a great tool, especially for those newer to investing.