In volatile periods, poorly diversified portfolios can feel like a roller coaster ride. Adding fixed income is usually the first step to providing diversification. Additional risk reduction can be achieved with exposure to alternative asset classes.
Institutional and ultra-high net worth investors have been utilizing this tactic for years. Traditionally, this meant things like high priced hedge funds and futures contracts on commodities. Thanks to the explosion in ETF offerings, individual investors can now also take advantage of asset classes outside of stocks, bonds and cash.
Alternatives consist of real assets like precious and non-precious metals, energy, agriculture, and real estate, among others. Many of these assets have the added benefit of to providing a good hedge against inflation. Perhaps more importantly, alternatives have historically behaved differently than traditional asset classes like stocks and fixed income—based on 30 year annual returns they are negatively correlated. As a result, adding them to your portfolio can actually reduce overall risk while simultaneously increasing return.
We conducted a study of two hypothetical portfolios. Portfolio 1 has no alternatives exposure and Portfolio 2 has a 10% allocation to alternatives. Even though Portfolio 1 has a 15% weight in cash, it still has an overall standard deviation higher than Portfolio 2 (which has 5% cash and 10% alternatives).
For most individuals, we recommend a low-single digit exposure to gold and a low single digit exposure to a basket of other commodities. For those seeking growth, a slightly higher weight to domestic and international real estate in the form of REITs is generally appropriate.
Data sources: Ibbotson Associates, MSCI, Gold.org, and BP.com. Calculations based on historical performance for the S&P 500, MSCI EAFE, 10 Year U.S. Treasuries, 10 Year Foreign Government Bonds, and 30 Day T-Bills. Alternatives asset class constructed using a hypothetical index of 50% gold and 50% oil. Portfolio standard deviation based on annual performance data from 1970 to 2010. Expected returns based on average annual performance included in source data: domestic equities since 1926, international equities since 1970, domestic and international fixed since 1926, alternatives since 1970, cash since 1926. This information is intended only to illustrate a hypothetical strategy. Past returns are no guarantee of future performance. There can be no assurance that any strategy will be profitable, or that the portfolios described above will perform better than the S&P 500 or other market-weighted index. Data tables do not reflect the impact of fees and expenses that would be incurred by a managed account or fund attempting to follow an indicated index strategy. It is not possible to invest directly in an index or strategy without fees and expenses.
Craig Birk, CFP®
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