By Barbara Young, Cypress Wealth Advisors
Just because someone is terrific at wealth creation doesn’t necessarily mean they’re equally good at managing serious money.
I was reminded of that during a recent conversation about the importance of alternative investments on a portfolio.
In my 30 years of investing and wealth management, I’ve seen many strategies come and go. One that is here to stay – and was previously accessible only to the wealthiest – is diversifying risk with alternative assets.
Alternative assets, also known as alternative investments, include everything from private equity and venture capital, to art, collectibles, real estate, and distressed debt or property. Many of these investments are readily accessible through ETFs and mutual funds, such as hedged investments and REITs. But many are not, such as direct investments in real estate and venture capital.
The Secrets of The Wealthy
Ultra high net worth investors and endowments have long known that alternative investments accomplish two key goals simultaneously: They increase returns and reduce risk.
Our own experience managing money for clients confirms the mountain of empirical evidence supporting the benefits of alternative assets.
In terms of risk management, alternative assets help investors inoculate themselves against systemic risk. These kinds of unforeseen events include the recent financial meltdown, government bankruptcies, inflation, regional conflict around the world, among others.
Avoiding a Common Mistake
Most investors understand the principle of diversification, but it’s easy to misapply the idea to an entire portfolio and not hold any alternative investments.
Many investors think about diversification in terms of stocks and bonds. Small cap vs. large cap vs. international. Corporate bonds vs. munis vs Treasuries.
In fact, asset class diversification is most critical, and alternative assets allow investors to spread risk across a broader range of investments that are not correlated to assets traded in the financial markets.
Alternative investments in private stock or an office building, or precious metals often do not move in the same direction as traditional assets in stocks and bonds. That means when the market is headed south, alternative assets may have less volatility.
Three Types of Assets
So how do you build a portfolio to increase return and reduce risk with alternatives? At Cypress, we incorporate three types of assets into portfolios. This strategy has worked very well for us over the years.
Convergent assets move up and down with the financial markets. These types of assets are traditional stocks and bonds. It’s important that every portfolio have exposure to these types of investments.
Divergent assets are largely immune from the volatility in the financial markets. These assets can include timberland, farmland, or distressed debt. Or they can be precious metals such as gold, which often moves in the opposite direction of assets traded in the financial markets.
Asymmetrical assets are those that give up a bit of the upside when the market is rising, but minimize the downside when the markets are cratering. Certain hedge funds constitute the overwhelming majority of these investments.
In fact, the best way to accumulate wealth is to systematically minimize significant losses.
When portfolios take a big hit, it usually takes a significant amount of time for assets to reach the same level before the correction. On the other hand, if your portfolio falls less, you may be able to benefit faster when the market recovers.
Deciding on the Right Allocation
What’s the right mix among all of these types of investments?
It always depends on the investor’s risk tolerance and objectives, but in our view, we recommend that only 40% of a portfolio be long-only stocks. The rest are in alternatives, including a healthy allocation to real estate. For comparison purposes, Harvard University has 50% of its endowment in alternative assets.
Alternative investments are no longer the privilege of those with substantial wealth. They are now available to everyone. The biggest mistake when it comes to alternatives is not considering them as part of your portfolio.