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How to diversify beyond stocks and bonds?
A reader asked: Since the stock market seems so fragile, and in the long term it seems far from certain that it is safe to entrust with a majority of our retirement and college investments, how else could we diversify and save? I know about the standard ways of diversifying like bonds, real estate, but are there other more creative ways?
There has been much discussed and written about the more conventional ways of investing and that we must now begin looking elsewhere to make money on our savings. I reject these discussions because the mere facts are that the stock market and the bond market have been providing very generous returns since March 2009 to those who have been willing to invest. For reference, the S&P 500 has more than doubled since the March 2009 lows while the bond market has continued to rise very nicely. So, for starters, maybe the traditional ways of investing are not so bad.
Let's also address the issue of fragility in the markets. I think this is a legitimate characterization considering what happened in 2008-2009, but we do need to look to history and ask if this has happened before and did we bounce back? The answer is yes to both of these questions. The market crash in 1929 provides us some historical context and in both cases the market bounced back. We could argue that the current market recovery is faster than it was back in the 1930's. What remains to be seen is if we hold these gains, or do we somehow experience a repeat of 1936 when the market experienced a 'double-dip' and lost about half its value. There is also the concern of how news impacts the markets. The fake twitter announcement earlier this week that caused the market to temporarily drop more than 100 points in seconds before quickly recovering is certainly a concern.
Let's discuss ways to better diversify our investments. Many mistakenly believe that investing in one or more US Large Cap mutual funds is diversified. It is not! One needs to first look to diversify their portfolio into small cap value stocks, international stocks (including small cap and emerging markets), as well as real estate investment trusts. And most importantly, bonds. If you are concerned about risk, you need to have a healthy percentage of your assets in bonds. Yes, they have a very low yield right now, but bonds are the anchor on your investment portfolio. When the seas of equity market volatility begin to get rough, the anchor of bonds will likely keep you from getting seasick!
Beyond these traditional investments one can consider commodities. There are many fairly low-cost commodity options available, but there is quite a large spread in how these investments are structured. While there is fairly strong evidence that commodities does have a beneficial role in a diversified portfolio, there is still some skepticism among professional investors since commodities themselves do not have an expected return beyond inflation. (Any return greater than inflation is pure speculation.) There are some sources of expected returns with commodity futures that can provide a rationale for holding this as a small percentage of one's portfolio. Bottom line on commodities is that the academic evidence is mixed but mostly favorable in small amounts.
Many folks are invested in rental real estate. This can be another way to diversify one's investments but in my opinion this requires a certain mentality. For one, you really need to know your local market. There is tremendous risk with rental real estate and to simply expect the property to appreciate is probably not something that should be counted upon. You need to certain of a strong income stream. If you have the time and skills to be a property manager, then maybe this is something to be considered, but rental real estate can be a sinkhole of expensive repairs so one should tread carefully.
Private equity is another consideration. As with any investment where there is a lack of information, one needs to realize that the risks are much greater with private equity. This is not something I would recommend for your retirement or college savings portfolio.
What about hedge funds? Most hedge funds are simply trading strategies. This is not a 'new' asset class as some would have you believe. Furthermore, the evidence is mounting that most hedge funds have failed to beat the S&P 500 over the past 10 years. As one executive at Dimensional Fund Advisors put it at a conference of advisors, "Hedge funds are investments for rich, stupid people." I should note that those who run hedge funds are the smart ones as they collect the very handsome management fees for managing the hedge funds.
In summary, there are ways to utilize what we know about markets to diversify beyond what we traditionally think of as a standard stock/bond portfolio. Think small cap, value, international, and emerging markets. Most importantly, recognize your own ability for equity risk. Writing down your objectives and investment policies in an Investment Policy Statement will help you to stay invested when the markets are not quite as friendly as they have been over the past year.
If you are interested in scheduling a complimentary consultation to discuss your situation, feel free to contact me at 609-620-1770 or firstname.lastname@example.org.