Alternative Investments: What You Need to Know

For many years, the concept of asset allocation was pretty simple; figure out the ratio of stocks and bonds that makes sense for the investor, and then break up the stocks into domestic and some international, and a mix of short, intermediate, and long-term bonds, and you’re done.  I think there have been some fundamental changes in investing over the last twenty years that make things a little more complicated than just this simple approach.

When I first got in the business, people still looked at the paper the next day to see how their stocks or mutual funds had fared the day before.  Now, news and information are instantaneous.  And for better or worse, a tweet or false claim made about a company on line can affect a stock before a company has an opportunity to respond, sometimes having negative consequences for long periods of time.

There is a concept known as “efficient markets”, which suggests that the stock market will perform optimally (that doesn’t mean it will go up, it just means it will perform as it is supposed to) when everyone has the same information at the same time, and can act on it at the same time.  With today’s lightning-fast information, I’m not so sure our markets are as efficient as they once were.

But the markets have performed very well over the past few years despite these challenges.  Are we due for a pullback?  I don’t really know, but it helps to be prepared in case we do have a dip in the stock market.

We also have some risk with bonds; if interest rates go up, the value of your bond holdings can go down.  We try to reduce this risk by shortening the maturity of bond holdings so that they are not affected by rising yields as much as long-term bonds would be.

For the past several years, I’ve been using another asset class to try and further reduce risk in clients’ portfolios: alternatives.  Alternatives are investments that typically do not fit in the categories of stock or bonds; these could be commodities such as oil and natural gas and precious metals, currencies, real estate, and so forth.  These types of investments usually have what we call “low correlation” with the stock and bond markets—they do not normally rise and fall in lockstep with the other asset classes.  In addition, there are several types of alternatives, particularly the natural resources and real estate investments, that often pay dividends that can complement other investments in a portfolio.

It’s important to note that alternative investments are not for everyone; most alternatives have minimums that are a little higher than typical investments, and sometimes they are not designed to be as liquid as, say, a typical mutual fund, and so the requirements for investor liquidity are typically a little higher.

If alternatives are used as part of an investor’s overall investment strategy, I typically use them for about 7-12% of the investor’s portfolio.  Using analysis tools, we can see how introducing alternative investments can many times reduce the overall volatility (up and down swings) the investor sees in their portfolio.  This becomes very helpful to the investor who is interested in taking income, but does not want to see a lot of fluctuation in their accounts.  Alternatives won’t get rid of fluctuations, but they may help smooth out the rough spots.

If you would like to learn more about alternatives or see if alternative investments may be a good option for you, please feel free to give me a call at (865) 474-8115 or email me at