When discussing “investing” and “asset allocation” most folks think of the mixture of stocks, bonds, and cash in their portfolio. While this is not necessarily wrong, asset allocation is more complicated than simply picking the appropriate pie chart or Morningstar style-box. With stocks at record highs and an increase in interest rates inevitable, it’s now more important than ever to be properly diversified.
As an advisor, I spend much of my time managing the risk associated with client portfolios. An important part of reducing the risk in any portfolio is to find asset classes that have a low correlation to one another. Many traditional asset classes tend to move in tandem during times of volatility. In other words, if two different investments always move in the same direction then we have done nothing to decrease the risk in a portfolio by owning both. The only thing we gain is a false sense of diversification by investing in more than one asset. This makes building a diversified portfolio an even greater challenge.
One way to potentially lower the risk of your overall portfolio is to use alternative investments. “Alternatives” are simply defined as assets that don’t fall into the standard categories of stocks, bonds, or cash. The reason we add alternatives to an account is that their returns typically have little or no correlation to those of stocks or bonds. The most commonly used alternative investments include commodities (oil, gold, silver) and real estate. The more complicated alternatives would include hedge funds, managed futures, foreign currencies, and derivatives.
Properly allocating a portion of one’s portfolio to an alternative strategy may help “smooth out the bumps” when there is increased volatility in the stock market as well as help immunize a bond portfolio against an inevitable rise in interest rates. In the past most alternative investments were reserved more for institutional and high net worth investors because of their complex nature, limited regulations, and lack of liquidity. Lately alternatives have become more available to the average investor through investments such as mutual funds, exchange traded funds (ETFs), and annuities.
While alternatives can help reduce the overall risk of your portfolio, every individual’s situation is different. Consult a financial advisor to see if alternative might be an appropriate addition to your portfolio.
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This article was written by C. David Tolson, III with Founders Investment Services. It was published in Founders Open Exchange Newsletter (July 2013).