Diversification is one of the fundamental principles of investing. It can reduce the risk of concentrating your assets on one sector of the financial landscape and reduces the overall volatility of your investment portfolio.
For many investors, diversification means owning different kinds of stocks and bonds. While that can be a good way to start an investment program, as you learn more about the risks and opportunities in today’s marketplace, you may want to broaden your portfolio to include alternative assets as well.
For example, bonds have enjoyed a 30-year bull market, providing a stable source of returns for many investors. But bond rates are at historically low levels, and as the global economy recovers, the Federal Reserve and the European central banks are likely to reduce their interventionist policies. That could lead to greater volatility in the bond markets and higher risks for investors who are over-allocated to that asset class.
Stocks have also enjoyed several years of strong market returns, following the losses of 2008-09. They traditionally outperform bonds, but are also far more volatile on a daily basis — an issue for investors who worry about how their portfolios are doing, on a short-term basis.
With these concerns, investors may consider putting more money into alternative assets, a broad category that includes real estate, hedge funds, commodities, private equity funds and infrastructure funds just to name a few. These assets perform in different ways under various market scenarios. They can help to reduce certain types of risks, and also open the door to potentially higher returns.
However, it’s important to understand that alternative investments may not be suitable for all investors, as some of these asset classes can be highly illiquid or speculative in nature. They are intended for experienced and sophisticated investors who understand the potential risks, which may vary from asset to asset and fund to fund — but can include higher costs, lack of information, manager risk and lack of regulatory oversight.
But before adding one or more of these alternative asset classes to your portfolio, you should talk with your financial advisor about your personal goals, what kind of returns you would like from your investment portfolio and what risks are of greatest concern. In other words, what kinds of outcomes would you like to see from your investments?
For example, if you are in your 30s, you may want to include alternative assets with relatively high long-term growth potential, even though their day-to-day market value may fluctuate. But if you are in your 70s and relying on income from your investments to pay your bills, you would probably be more concerned about risks like loss of principal or inflation, which can erode your buying power.
With those concepts in mind, it’s important to select alternative assets that provide a good match for your investment goals and address the risks of the financial world.
For example, owning real estate or infrastructure assets can provide protection against inflation for investors who rely on a steady income stream. A real estate fund can increase its rental rates for tenants, and an infrastructure fund that owns toll roads or bridges can increase fees should there be a rise in inflation.
Investors who are more interested in seeking to obtain a higher return could add private equity or hedge funds to their portfolios. That strategy might encompass actively managed funds that strive to take advantage of short-term or tactical opportunities in the markets.
In any case, owning only stocks and bonds may not be the right approach to constructing your portfolio. Alternative investments that don’t correlate with stocks and bonds could reduce your overall investment risk and potentially improve portfolio performance. Therefore, it’s important to recognize that these alternatives are available, learn about them, and talk with your advisor to see if they make sense for you.
Andrew Menachem, CIMA, is a Wealth Advisor at the Menachem Wealth Management Group at Morgan Stanley in Aventura. Views expressed are those of the author, not necessarily Morgan Stanley, and are not a solicitation to buy or sell any security. The strategies and/or investments referenced may not be suitable for all investors. Follow Menachem on Twitter @AMenachemMS