Diversification is a familiar term to most investors. In the most general term, it can be summed up with the phrase: "Do not put all of your eggs in one basket."
Certainly that statement depicts the essence of the issue, but it affords little guidance or insight into how to assemble a true diversified portfolio. The lack of education regarding true diversifications is a predominate issue for many investors.
Diversification is key aspect of a solid investment strategy. To diversify means to spread your portfolio over many types of investments and over different specific investments within each category. Although many Financial Advisors will advise it, diversifying across many mutual funds or across shares in many sectors is not true diversity. Modern Portfolio Theory tells us that holding a well-diversified 'basket' of investments can be one of the best ways for individual investors to reduce risk for a given level of performance. But a portfolio consisting of only stocks, bonds and mutual funds may not be sufficient to provide true diversification.
Many investors that primarily invest in mutual funds unlawfully believe that by investing in two or more mutual funds, they increase the level of diversification in their capitals. Make note that most stock mutual funds own dozens or even hundreds of individual stocks. The added diversification benefit you get from adding yet another stock to your portfolio becomes less significant as the number of stocks you own grows. For instance, you may benefit greatly by increasing the number of stocks you hold from 4 to 20, but going from 100 to 200 may not have as great an impact. Another consideration, many mutual funds may own exactly the same securities. For example, if you own an S & P 500 index fund and a mutual fund that focuses on large-cap technology companies, the odds are that both of them will own big tech stocks.
As we state earlier, we can sum up diversity as "Do not put all your eggs in one basket". But there are several different types of diversity to take into consideration. For the most part investors do a good job of identifying the most basic needs for different investments; they do not always succeed in reducing the risk that comes with assets which prices tend to move in similar directions.
A Non-Correlated Portfolio: True Portfolio Diversification
The Modern Portfolio Theory says that the risk of any investment can be reduced and / or performance increased by forming a portfolio of diverse and non-correlated assets. Simply put, a truly diversified portfolio contains not only a range of different asset types, but also assets that have low correlations to one another. Constructing your portfolio this way will reduce the likelihood that your assets will move in tandem, which can be especially important when the broader markets may be down and diversification may be most needed.
Alternative assets may be a good way to diversify a portfolio due to their low correlation to stock market performance. For these they have become one of the fastest-growing sectors in the investment arena. Alternative investments can provide qualified investors viable options to the stock market and may help respond to different market conditions.
Some alternative investments have shown strong historical performance against the markets. But as with all investments it is important to remember that past performance is not a guarantee of future results. A key point is that some have historically proved to have low correlation with broader market activity, including stocks and bonds. For this historical low correlation, alternative investments may be an attractive addition to traditional capitals. Integrating alternative investments into a portfolio may have diversification benefits. For the right investor, allocating a portion of your overall portfolio to alternative investments may help create a portfolio with the potential for improved performance in both bull and bear markets. (Please note, correlations may change over time. Not all alternative investments provide low correlation to traditional markets).
So, what is an alternative investment? Many have their own definition of an alternative investment. Someone who is ultra conservative might consider stocks and mutual funds to be alternative investments when compared with fixed-income investments such as bonds or fixed annuities. On the other end of the spectrum, a very sophisticated investor may not consider the well-known alternative investments, such as hedge funds, futures, and options to be alternative, since they may deal with them all the time.
Here we will define the term "alternative investment" as any investment in which a successful performance does not depend on continued upward movement in the stock market.
A basic list of so-called alternative investments may include: options, futures, and precious metals. In addition, the following would have considered alternative investments: hedge funds, managed futures funds, private equity offerings, and other funds that use derivatives. But with a few exceptions like life insurance and collectibles, the list of alternative investments allowed in a tax deferred retirement account are almost endless *.
Examples of Alternative Investments for a SDRA * –
· Residential / Commercial Real Estate
· Business Start ups
· Tax liens, business loans, and mortgages
· Private Stock Offerings
Other examples of use for a SDRA * –
· Raise private capital
· Private mortgage lending
· Invest in a friends venture
· Lend money to a local developer
· Pool funds with others for a larger investment
· Invest in what YOU know
In conclusion, this overview of diversification and the importance of alternative investments is not intended to discourage equity investments-but to argue for a more balanced, well rounded, and non-correlated portfolio of investments. Investors wanting to diversify his or her portfolio with alternative investments are strongly encouraged to seek the expertise of professionals that specializes in the SDRA market.
* Some restrictions apply. It is important to consult with a professional regarding IRC Pub 590 regarding regulations before investing.
Securities offered through USWA, LLC, Member FINRA / SIPC, and advisory services through USFA, LLC, a registered investment advisor. USWA / USFA is not an affiliate of CMS.