THE STOCK MARKET recently hit yet another all-time high. But instead of unalloyed glee, many investors are struggling with mixed emotions. They’re thrilled at their gains. But at the same time, they’re hesitant to put more money into a market that has already gained so much.
Result: Folks have been asking, “Isn’t there anything else I can buy?” Often, this leads to questions about alternative investments. Below is an introduction to the topic, along with my recommendations.
What are alternative investments? In simple terms, an alternative is any investment that isn’t a stock or a bond, the two pillars of a traditional investment portfolio. Alternatives include commodities (such as corn, livestock, crude oil and precious metals), real estate, stock options, futures contracts and other esoteric investments.
In addition, the investment industry uses the term alternative to refer to any investment structure which differs from a traditional mutual fund or exchange-traded fund. The best known are private equity, venture capital and hedge funds, all of which are generally structured as private partnerships.
What benefits do alternatives offer? There are two reasons you might consider alternative investments. First, you might expect better returns. For instance, if you’re worried that the stock market is due for a breather after rising for nearly 10 years, you might look to alternatives.
The second reason is diversification. When you add alternatives to your investment mix, you’re looking for things that will zig when the rest of your portfolio zags. In mathematical terms, you’re aiming for things with a low correlation to stocks.
Do I need alternatives? Diversification is usually a good thing. But before you jump headlong into alternatives, take some time to evaluate what you already have. Though you may not have thought about it in these terms, it’s possible that you already have alternatives exposure of one kind or another. If you have a rental property or own a business or your job provides a pension, you already have assets that are not closely correlated with stocks. These assets may provide all the diversification you need.
What if I want more diversification? If, after evaluating your personal balance sheet, you decide you need more diversification, should you invest in alternatives? Unfortunately, the track records aren’t great for most mutual funds that focus on alternative investments. In a 2015 study, The Wall Street Journal found that the single best form of diversification during a stock market downturn—when you need diversification the most—came not from alternatives, but from the simplest of traditional investments: bonds.
Long-term data confirm this finding. Over the past 10 years, bonds have provided far better portfolio diversification than virtually every other type of investment, including alternatives like commodities, private equity and real estate. Bonds have actually demonstrated negative correlations to stocks, meaning that when stocks have gone down, bonds have gone up, and vice versa. While there’s no guarantee bonds will always behave this way, there are logical reasons they usually move inversely to stocks. That is why I believe strongly that a simple portfolio of stocks and bonds (including cash investments, which are really just very short-term bonds) is the most effective way to achieve diversification.
Does this data mean I should never invest in alternatives? The world of alternative investments is vast and diverse, and I want to make an important distinction: The sorts of alternatives that I would avoid are the alternatives funds that are marketed to the public. As I have noted elsewhere, there are definitely hedge funds and other alternatives that have delivered off-the-charts performance. But these funds are rarely available to the general public.
That doesn’t mean you should avoid alternatives altogether. I’m just advising against the retail, mass-market variety. The best opportunities, in my opinion, will present themselves individually. For example, it might be a startup company in your industry or a real estate rental unit in your community. These are the sorts of things that may have outsized potential.
But you’ll need to evaluate each prospective investment on its own merits. In addition to estimating the return potential, you’ll want to consider the investment’s liquidity, costs, tax impact and the track record of the individuals who will be managing it. Most important, ask yourself whether the investment’s strategy passes the commonsense test. The investing genius Peter Lynch once said that he would never invest in anything that couldn’t be illustrated with a crayon. That’s an especially important litmus test when evaluating alternatives.
Adam M. Grossman’s previous articles include Buy What You Know, Staying Focused, Eight Heroes and Separated at Birth. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.