Given their liquidity and ease of access, stocks have become the natural starting point for most investors. Whether it’s through a 401(K) or personal account, many of us have most of our capital tied up in equities. This means there’s little to no diversification–simply because we don’t know any better.
This means we can be overly exposed to every jolt and shock from the markets. When news hits the headlines, investors act on emotion and stock positions won’t always move rationally.
Reducing your dependence on stocks and looking elsewhere for returns is worth considering. A move away from the high liquidity of the equity markets will be necessary but this also means increased insulation from panic-driven equity selloffs.
So how can the individual investor put this into practice in the new year?
First, you’ll need to decide which type of alternatives you want to add to your portfolio. There are many types to choose from–real estate is one of the easiest to turn to. Thanks to ETFs, REITs, and crowdsourcing platforms like DiversyFund, these investments are just as accessible as stocks and the beginner investor can quickly become just as diversified as the experienced professionals.
Next, you decide how much you should allocate. High net worth individuals might have the luxury of being able to leave millions tied up in illiquid assets for years at a time. But for many, having fast access to some funds is a key component when deciding to invest. That’s why you’ll need to choose the amount that works for you. An amount you are comfortable leaving untouched for an extended amount of time, while you have access to other money for short-term goals.
The “100 Minus Your Age” Rule
When considering how much of your portfolio or net worth to allocate to real estate, you must always keep in mind your age and investment horizon.
A well-known rule of thumb for stock allocation is to subtract your age from 100 and make that number your percentage allocation for equities. The idea here is that the younger you are the more risk you can afford to take. A 30-year-old following this rule would allocate 70% of their portfolio to equities. The remaining 30% would easily allow for a 10% slice going to real estate with the remaining 20% perhaps being split between bonds and cash.
As our 30-year-old friend gets older and accumulates more capital, they’ll gradually reduce their exposure to stocks and increase their allocation to alternatives.
Yale Paves the Way
It’s worth noting however that diversification wasn’t always in vogue. The stocks, bonds, and cash model was around for over a century when an institution more commonly known for groundbreaking research set a new trend in finance.
Yale University, the Connecticut based Ivy League with an endowment fund only second to Harvard in terms of size, was the thought leader to do things differently.
In the early 1980s, Yale’s endowment fund operated like any big investment fund; 80% of their portfolio spread between stocks, bonds, and cash. Then David Swensen took over and in his three decades at the helm, has completely flipped that on its head.
Swensen wanted to reduce the fund’s exposure to the volatility inherent in equity markets. The high liquid nature of stocks allows for sudden and irrational market moves, driven by panicked and emotion stricken investors.
A move away from stocks and bonds meant a move towards non-traditional assets like real estate, venture capital, and natural resources–all highly illiquid by definition. But with an investment horizon as long as Yale’s 300-year-old history, having a liquid portfolio pales in priority to steady, reliable returns.
Domestic equities, bonds, and cash now collectively barely account for 10% of their portfolio with about 90% in non-traditional, illiquid holdings. They’re aiming for a 10% asset allocation to real estate specifically in 2020.
Diversification in non-liquid assets and avoiding violent stock market swings has become their modus operandi. They don’t need the liquidity typically offered by stocks, bonds, and cash–therefore invest in longer-term focused assets.
All this has led to a 12.6 percent return per annum over the past 30 years, comfortably outpacing the S&P 500, and with much less volatility. Consider this, compared to the S&P 500’s eight down years since 1985, the Yale endowment fund has registered only one; 2009.
With funds like Yale’s going against the grain of traditional allocation and succeeding, it’s hard to not consider following suit.
Whether you allocate 10, 20, or even 30 percent of your portfolio to alternatives, always consider your risk tolerance, age, and investment horizon.
Even if your capital base is a fraction of Yale’s, the average investor can still adopt their philosophy. Illiquid assets can offer natural protection from short-term volatility without sacrificing any long-term return potential.