What diversification options are there beyond stocks, bonds and commodities? A member recently asked me this question. Here is an expanded version of the answer I sent him.
Not all stocks and bonds move in sync with one another, and making sure your holdings in both are properly diversified is the best place to start. If you have never given thought to your stock and bond allocations, you need to adjust these before moving on to other asset classes. Even if you have paid attention to your allocations in the past, review your portfolio annually (or every six months) to ensure the percentage invested in these two asset classes makes sense given your goals and tolerance for risk. (AAII members have access to asset allocation models that show suggested diversification strategies.)
Stocks – Simply splitting your holdings between U.S. large-cap, U.S. small-cap, developed international market and emerging market stocks gives diversification benefits. Though correlations (the extent to which different assets move in sync with one another) become closer during financial crises, they move apart during periods of recovery. Over the long term, each of these stock categories will generate different types of returns.
Bonds – Though the outlook for interest rates is uncertain, bonds continue to play an important role in your portfolio, since they provide both income and return on capital. Diversification can be achieved by holding a variety of U.S. government, corporate and foreign bonds. If you are worried about inflation, shorten the duration of your holdings, which will reduce the sensitivity of the portfolio to interest rate changes. (My bond funds have average durations of between four and five years.)
REITs – Real estate investment trusts provide a stream of income as well property ownership. They are sensitive to interest rate changes, but are more correlated with stocks than bonds. Keep in mind that if you own a house, you are already invested in residential real estate. If you have a mortgage, you’re investing in residential real estate on margin. Thus, a REIT focused on commercial real estate may make more sense.
Master Limited Partnerships – MLPs are mostly involved in the oil and natural gas pipeline business. They have a unique structure that results in them paying relatively high yields, but MLPs tend to be more correlated with stocks. MLPs come with potential tax issues and their distributions must be monitored when they are held within an IRA.
Preferred Stock – This is a hybrid security that offers a stream of dividend payments and limited voting rights, but is sensitive to interest rates and should be monitored for credit quality. This is why preferred stocks share return characteristics with both stocks and bonds. In a portfolio, they would be funded with some money that would otherwise be allocated to stocks and some money that would otherwise be allocated to bonds.
Annuities – These are contracts that return a stream of income over a certain period of time. The advantage is that they can guarantee you a minimum level of return. The disadvantage is that they can be complicated, have high comparative costs and offer limited upside, especially compared to the potential returns realized by investing in stocks. When used properly, annuities can offer financial security and can offset part of your bond holdings.
Precious Metals – Gold’s value has historically been inversely correlated to currency valuations over long periods of time. Over shorter periods, it is influenced by shifts in sentiment. Precious metals are a hedge for your portfolio that is unlikely to create wealth unless your timing is really good. An ETF can remove many of the headaches (including the threat of theft) associated with buying and storing gold and other precious metals. Arguments can be made to use both stock and bond dollars to buy precious metals; if pushed, I would suggest allocating to gold from your stock holdings given the lack of cash flow.
Commodities – A basket of commodities, including precious metals, energy (e.g., oil) and agricultural goods (e.g., wheat) provides a hedge against inflation. It also lowers the volatility of a portfolio holding only stocks. Commodities are subject to sharp swings in volatility. Futures contracts are used to invest in these (accessible via mutual funds and ETFs), but come with an additional level of risk and complication. If used, 10% to 15% of the money invested in stocks should be shifted to commodities.
Hedge Fund Strategies – A growing number of mutual funds and ETFs follow strategies designed to mimic those used by hedge funds. These can provide different returns than you would otherwise get in a more traditional investment. The downsides are that you will be paying higher fees, the strategies can be complex, and they are risky by themselves. The suggested allocations discussed at a Morningstar conference on alternative investments that I attended on Tuesday ranged from 0% to 25% of portfolio dollars (funded from both stock and bond allocations), with 15% used as a benchmark. One fund manager said that anyone who does not fully understand the strategy being used should avoid hedge funds and any investments that mimic them. This is good advice that applies to any investment offering.
Currencies – Foreign currencies can help protect your portfolio against fluctuations in the U.S. dollar. They are volatile, and an individual investor is pitted against traders with access to economists and offices staffed 24 hours a day. (Foreign currency exposure can also be obtained by investing in foreign bonds.) From an allocation standpoint, use portfolio dollars from both stocks and bonds if you are holding a currency fund for an extended of period of time and from stocks if you are going to trade currencies actively (which I do not recommend).
The Role of Cash
The one asset class not mentioned above is cash. Cash and its equivalents (money market funds, CDs, Treasury bills, etc.) give you both safety and flexibility. The primary advantage of holding onto cash is having the ability to pay for unexpected expenses and take advantage of new, attractive investment opportunities when they appear. The downside is that inflation erodes your purchasing power. (Remember when putting $5 in the gas tank actually allowed you to drive somewhere?)
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