This article originally appeared on Forbes.com.
Alternatives are probably the most poorly understood corner of the investing universe. That’s too bad, because they can deliver just what investors need most right now: higher current income. But they can also provide inflation protection, cushion the (inevitable) next market downturn, and stretch return singles into extra base hits.
The reality is that stocks and bonds constitute only a fraction of potential investments. Indeed, many of the world’s best and smartest investors– Yale and Harvard to name two– keep well under 20% in traditional securities. Instead, they focus on dozens of other categories, from royalties to timber, from arbitrage to venture capital, and from infrastructure to water. The reason is plain and proven: over time, this more diverse approach provides higher returns with less overall risk. That’s why Yale’s endowment is up over 100% during the past decade, while most investors are barely at breakeven.
The good news is that, although elite investors have had this field to themselves, that’s changing fast. Now, most alternative strategies are widely available in investor-friendly formats, including mutual funds and ETFs; and nearly all investors can expand their horizons to create more robust portfolios.
The Four Jobs
A lot of talk (and marketing material) about alternatives focuses on some pretty heady academic stuff, like modern portfolio theory and the “efficient frontier.” That’s all fine, but it misses the point investors actually care about: exactly what alternatives can do for them. So let’s zoom in on that.
There are 4 jobs for alternatives in a portfolio. Here they are:
1. Higher current income. When junk bonds pay barely more than 4%, a rate traditionally associated with US Treasuries, you know savers have a problem. And aside from that total lack of yield, the risk-reward equation in traditional fixed income instruments is terribly out of whack– should rates rise back towards normal, the value of existing bonds will be crushed.
Alternatives can play a crucial role here. Numerous options– multiclass ETFs, MLPs (Master Limited Partnerships), pharmaceutical royalties, peer-to-peer lending, and TREITs (timber real estate investment trusts) to name a few — offer strong current income with little interest rate risk. We’ll dive further into this subject tomorrow, and (excuse the plug) you can get a complete rundown of the options in The Alternative Answer, my brand new book from Harper Collins.
2. Minimizing Losses. Alternatives can reduce the risk of losses in two ways. One is obvious: greater diversification. Several asset classes tend to zig when the stock market zags, and adding them helps immunize you from big losses. More famously, many hedged strategies– now available in mutual funds with low fees — provide an important insurance function. By the way, the common idea that they should be “beating the market” all the time is simply wrong. The main idea, instead, is to beat it when the market declines.
That is why these strategies have indeed powerfully outshone stocks over the past decades. Remember, a 40% loss (as in 2008) requires a 67% gain to get back to even… and that assumes you have the stomach and the investing time horizon to do it. The key to long term wealth accretion is incredibly basic: don’t lose the money you already have. On Wednesday, we’ll have more on this.
3. Return Multipliers. The main reason the big endowments have so dramatically outperformed average investors has been their private equity, venture capital, and other non-public investments. These often aim for returns of 2 to 4 times the capital invested, instead of 2 to 4 percent on it. The news here is that so-called “private market platforms,” and key legal changes, have recently made these sorts of opportunities much more accessible to typical investors.
If you’ve got the liquidity and risk tolerance, these more aggressive strategies are definitely worth a look. They’re on the calendar for Thursday.
4. Purchase Power Protection. Whether we’re in the early stages of a “currency war” or not, global central banks have unleashed a tidal wave of liquidity since the crisis began. You don’t need to be an economist to know that serious inflation, and a dramatic loss of purchasing power, are clear threats.
Gold is the classic hedge, but others might be more interesting these days. How about farmland, art, infrastructure, timber, TIPS (Treasury Inflation Protected Securities) or water rights? Several options generate current income while also guarding against currency devaluation and inflation. Check in on Friday for more.
Naturally, none of this means that you should just leap in to alternatives. Like any other investment, everything depends on exactly what you need, the quality of the manger, the fees, liquidity options, and a host of other factors. Alternative investing is hardly a no-brainer. But it is a critical part of building a sturdier, more profitable portfolio.
So each day this week we’ll focus further on one of the four jobs. Then we’ll shift to a once-a-week drilldown on exactly how you can best use alternatives to meet your goals.
I hope you’ll follow these columns — and me, on twitter @bobrice3, and on Bloomberg TV’s Money Moves. Meantime, please check out www.altanswer.com, where you can learn all about alternatives in 4-minute videos. And for the complete story on all these topics — including 32 different investment ideas– don’t forget my book, The Alternative Answer.