If history repeats itself, the current bull market will end soon. Will you be prepared if stock prices fall?
But diversifying your portfolio by investing in a variety of stocks and bonds is no longer sufficient. Stocks and bonds historically were negatively correlated – when one went up in price, the other went down, which provided balance and ensured that investors would limit their losses.
During the current bull market, which is among the longest in history, the Federal Reserve Board’s easy money policy caused stocks and bonds to rise together. Now, as the Fed begins to unwind its $4.5 trillion bond portfolio, what will happen if they fall together?
Many Varieties of Alternatives
To prepare for that possibility, investors may want to consider including alternative investments in their portfolio. Alternatives, or alts, include every asset except stocks, bonds and cash. Many alts are hard assets, such as real estate, commodities such as a corn and grain, timber and precious metals. Others include private equity and hedge funds. Art, antiques, wine and other collectibles are also considered to be alternative assets.
There are also a variety of alternative strategies, which revolve around a specific approach to investment, rather than specific assets, such as long/short, market neutral and opportunistic investment strategies.
Not long again, alternative assets were available only to qualified investors – those who met specific requirements, such as having a net worth of at least $1 million. Today, though, there are a growing number of opportunities for even average investors.
Anyone, for example, can invest in alts through a self-directed IRA. Investors can also invest in alts through a wide range of exchange-traded funds or closed-end funds or through crowdfunding platforms.
Alts a Growing Asset Class
Even with the stock market setting new records, alternatives have been growing rapidly in recent years. Investors have $7.3 trillion invested in real assets, private equity and hedge funds and, as McKinsey & Company noted in its report, Thriving in the New Abnormal, “global growth in alternatives continues to outstrip that of traditional assets.”
Likewise, a recent study by Investment News and Blackrock, published as Alternatives in the Mainstream, says that alts now account for about 10% of the typical portfolio and average allocations could increase to 14% within three years.
Alternatives in the Mainstream, which is based on interviews with 392 financial advisors, found that:
- 83% of clients are interested in alternatives
- 67% of advisers say that clients’ “lack of understanding is a key impediment” to adding alternative allocations
- 51% of advisers said they themselves had “a need for more insight into portfolio construction with alternatives”
Given the wide variety of alternative investments, it’s not surprised that some are riskier than others. Some alternative investments are also illiquid, which makes them difficult to value and difficult to sell quickly.
Given the risk involved, it’s important to know what you’re investing in and to limit your investments. Rather than putting all of your money into gold, for example, you can keep a set allocation in precious metals and use it as a hedge in case stock prices drop.
Also keep in mind that you’re investing long-term and plan accordingly, so that you are able to sell your assets when you need cash.
It’s also important to diversify your alternative investments. Master Limited Partnerships (MLPs), which invest in equipment for drilling and transporting oil and natural gas, provided investors with double-digit returns a few years ago, but have performed poorly in recent years as oil prices have dropped.
Like many alts, MLPs are subject to significant price swings. No one knows with any certainty how they will perform at any given time.
Alternative investments can help manage risk at a time when the stock market appears to be overpriced and they can contribute to total return, but it’s important to proceed with caution.