Financial Poise

When Stocks Decline, Alternative Investments May Help (Part 2)

Diversification is Almost Always a Winning Strategy

As noted in “When Stocks Decline, Alternative Investments May Help (Part 1),” the impact of asset allocation on volatility and returns has been widely debated, but a landmark study from the CFA Institute found that between 1974 and 1983, diversifying among a variety of asset classes – and keeping a steady allocation by rebalancing – accounted for 93.6% of the variation in the quarterly returns of the 91 large U.S. pension funds.

The Role of Alternative Investments

How assets are allocated, of course, also matters. While the studies cited in Part 1 show that historically, asset allocation has helped reduce volatility, a traditional allocation of stocks, bonds and cash equivalents may not provide the asset diversity needed to adequately manage risk.

Historically, stock and bond prices have generally moved in opposite directions, so a loss in one asset class could be buffered to some degree by a gain in another asset class. However, as investors saw during the global sell-off in 2007-2009, traditional asset classes like stocks and bonds can occasionally move downward at the same time.

At the same time, many alternative investments have been proven to have either no correlation or little/negative correlation with the price behavior of stocks or bonds. If an asset class has a negative correlation with stocks, it typically will drop in value when stocks rise in value; conversely, it will likely rise in value when stocks drop.

[Editor’s Note: Worried about a bear market? Interested in additional perspectives on diversification and alternative assets? Check out “Diversification, Correlation and Alternatives in a Scary Market.”]

One way to view the diversification or non-correlation aspect of alternative investing is provided by J.P. Morgan. For the one-year period through December 31, 2017, investors could measure the off-setting influences of commodities, REITs, hedge funds and Private Equity versus traditional equity and fixed income investments. Here is what they found:

  • REITs had a negative correlation with large cap stocks with half of the volatility.
  • Hedge funds, in contrast, nearly correlated with large caps for the year – but with less than half the volatility.

A Wide Spectrum of Alternative Investments

There are many different alternative assets for investors to consider. By its broadest definition, alternatives include all assets that are neither stocks nor bonds. Private equity, including investments made through crowdfunding platforms, is an example. Many, though, think of alternative assets as hard assets or real assets; tangible items that hold inherent value, such as real estate, currency and commodities.

Gold is an alternative that people have been investing in for 2,700 years. Corn and grain, farmland, timber and managed futures are all alternative assets. There are also a variety of alternative strategies, which revolve around a specific approach to investment, rather than specific assets. A few examples include long/short, market neutral and opportunistic investment strategies.

[Editor’s Note: There are many options for alternative asset investing. For a deeper dive into those options, check out the excellent webinar “Advanced Investing Topics.”]

What Should Investors Do Before Investing in Alternatives?

Jeffrey Kelley, the senior vice president of Equity Institutional, stressed that investors interested in alternative investments should speak with a financial professional.

“Because the investments are usually complex, alt-minded investors should speak to their financial professional before making a commitment,” Kelley said. “The custody of alternative assets such as real estate investment trusts, mortgage notes, limited partnerships, limited liability corporations, precious metals, joint ventures and private equity can be substantially different from traditional investments.”

Kelley added that there are also administrative benefits to working with financial professionals.

“Choosing an adviser who works with a custodian that specializes in alternatives can help simplify the administration process, too,” Kelley said. “For the retirement-minded, alternative opportunities can be accessed through individual retirement accounts such as self-directed IRAs.”

To manage expectations, it’s important to have enough knowledge of alternative investments to understand how to use them to diversify. It’s important to recognize that alternative investments can also be volatile – and like other investments, they involve risk, including possible loss of principal.

The stock market may continue breaking records in 2019. However, like the law of gravity, what goes up must eventually come down. While no one knows when the next bear market will occur, investing a portion of your portfolio in alternatives may help tame future bears.

[Editor’s Note: This is part two in a two part series. For further insights on the role of alternative investments, check out “When Stocks Decline, Alternative Investments May Help (Part 1).”

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About John Drachman

As an award-winning writer, John developed marketing communications initiatives for dozens of money managers for more than 20 years. John combines editorial skill and marketing knowledge in helping advisors, money managers and service providers to grow and retain assets.

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