The appropriateness of alternative assets in an investment portfolio has been in the news a lot lately. The August 16-17th edition of the Wall Street Journal, alone, had two articles on the subject. One, Do Hedge Funds Belong in a 401(k)? by Jason Zweig presents arguments by experts who have differing views on the subject. The other, Is Your Portfolio Too Diversfied? by Walter Updegrave answers the title’s question by preaching moderation. That is, Updegrave counsels that although diversification is appropriate, taking it to an extreme can be counterproductive. Both articles are worth a read.
Before reading them, however, it’s important to make sure you don’t suffer from the common misperception that adding alternative assets (i.e. anything other than publicly traded stocks and bonds) will make your investment portfolio more risky. But risk is a relative question. That is, when we say something is more risky, you need to ask: more risky than what?
Of course the answer is that we’re comparing the riskiness of stocks and bonds, on the one hand, with alternative assets, on the other. But wait. We’re not really talking about a single investment. Rather, we’re talking about the risk that the value of your investment portfolio will go down.
Stated another way, even though a particular alternative asset (say, for example, an investment in a private placement) may be more risky than a particular more mainstream assets (say, for example, an investment in a blue chip stock), a portfolio consisting of only blue chip stocks is more risky than is a portfolio consisting of a mix of blue chip stocks and alternative assets. Investment professionals refer to the selection of a mix of assets as “asset allocation.”
Allocating some of your money into blue chip stocks and some of your other money into alternative assets is just an example of a broader concept: dividing your savings into multiple classes of investments which are not likely to be impacted the same way as each other by various events is a key to lowering the risk that your overall investment portfolio will go down.
Note the distinction generally made between the words “allocation” and “diversification.” When you pick investment classes (i.e. public stocks, bonds, private companies, gold, land, etc) that is allocation whereas the investments you make within a particular asset class (i.e. specific public companies) speaks to diversification.
The old wisdom was that a mix of stocks and bonds would provide appropriate diversification. Indeed, until the 1970s, U.S. investors were typically invested in U.S. stocks, bonds, and cash. By the 1980s, some investors began to allocate some money into publicly traded foreign securities, PE, VC, commodities, and real estate. The trend of more diverse asset allocation has continued to this day. Why? Experience.
Study after study has shown that good asset allocation among investment classes is much more important on overall performance of most peoples’ portfolios than is the way you diversify within each asset class.
Depending on your circumstances, allocating into alternatives may make sense. Keep in mind, however, that the very notion of the “alternative” asset class is a misnomer because the wide range of alternative assets is way too broad to be considered a single asset class. Instead, if and when you decide to allocate some investment dollars into alternatives, you next will need to decide which alternatives to invest into.
Alternative assets are not for everyone. And even when they are appropriate, the percentage of one’s total portfolio that should be invested in alternatives should generally be very low (think low single digits). However, if you have more than a million dollars invested then, as a rule of thumb, you should at least take the time to consider whether allocating some of your portfolio into one or more alternative asset classes makes sense for you.
For an article on thinking through your asset allocation strategy relative to the specific risks posed by alternatives see Allocating Your Portfolio to Alternative Investments
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