Many investors view their alternatives allocation as a hedge—essentially as insurance against a stock market decline. This misperception is holding their portfolios back.
Insurance only pays off if a negative event occurs, though it costs money up front in the form of a premium. It sure pays off if you’re caught in a catastrophe like a house fire. But if you don’t end up needing it, you’ve often sunk the cost year after year.
Now imagine instead an insurance policy that paid you for every year you didn’t need it. That’s how alternative strategies actually work—at least those that are true diversifiers.
These investments are designed to potentially increase your portfolio’s performance over time by delivering both lower risk and increased returns. Here’s why alternatives, specifically true diversifiers, are more than a portfolio hedge.
1) Diversification is a profit center in any market environment
In today’s low interest rate environment, there’s only one factor driving performance in most portfolios: equity risk. Creeping correlation between stocks and bonds means that today’s investors are unknowingly stuck with a one-piston engine.
Adding true diversifiers to a traditional portfolio is like adding a second piston to that engine. Rather than relying on one piston to do all the work, an engine with two pistons firing at different times is more efficient—and creates a smoother ride. This is because true diversifiers seek a different source of risk.
A hedge merely protects. A true diversifier aids with long-term compounding through diversification. In this way, it can potentially deliver increased returns.
2) True diversifiers can balance risk in traditional portfolios
Where hedges are defensive strategies only designed to offset losses in case you need it, true diversifiers can balance out fluctuations in a traditional 60/40 stocks and bonds portfolio.
Historically, true diversifiers have had low to negative correlation to stocks and bonds in declining markets. By investing in alternative risk, you increase the likelihood that your diversifiers do what you need them to do in challenging market environments —stay uncorrelated to stocks and bonds. This adds valuable protection to traditional portfolios.
3) Baked-in defense means there’s no need to try to time the market
By viewing alternatives as hedges, investors are essentially trying to time the market by using an asset class tactically. Timing the market is one of the most difficult things to do consistently, and most professional investors don’t even attempt it. By allocating enough to your alternatives sleeve up front, and viewing results over the long-term, investors won’t fall into the market timing trap. This allows investors to achieve their financial goals with a lot less stress.
Investors no longer need to rely on a one-piston engine. Adding a true diversifier can boost diversification in a traditional 60/40 stocks and bonds portfolio. This asset class is more than a hedge—it can be a profit center.