The Most Worrisome Trend In Investing: Confusion

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The Most Worrisome Trend In Investing: Confusion

Which alternative investments really deliver diversification?

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According to our latest research with the Financial Planning Association (FPA), even financial advisors struggle to understand what truly diversifies a portfolio—and the major benefit that diversification can bring. Their responses uncovered several myths about alternative investments that persist in the investment world.

Respondents hit on one very pervasive myth: REITs are one of the best diversifiers in alternative investments.

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The right home for REITs

Since REITs manage a variety of large commercial properties, they do differ from stocks and bonds. But compared to other alternative investments, they don’t deliver true diversification—lower risk in down markets and increased returns.

In fact, REITs maintain a nearly 60% correlation to a stocks and bonds portfolio in declining markets. As a diversification strategy, REITs are DINOs: diversifier in name only.

Different isn’t necessarily diversified

While it’s true that REITs take a different approach to investing, it’s simply not true that this approach delivers the portfolio diversification from stocks and bonds that individual investors need. While many investors assume they’re adding diversification to their portfolio by allocating to REITs, they’re generally unaware of how ineffective REITs have been in declining market conditions.

That’s because by investing in REITs, you’re investing in a company. Sound like another part of your portfolio? REITs share another quality with those other corporate entities listed in indices: to a large degree, they both take the same macroeconomic risks.

On the surface, it sounds like REITs are different enough to deliver diversification for individual investors. However, from the perspective of a balanced portfolio, REITs take too much macroeconomic risk to help during market declines. They may add value to a portfolio, but based on their historical performance, it’s best not to lean on them heavily for diversification.

Clarity among the confusion

So, which alternatives are the most effective diversifiers?

FPA survey respondents ranked MLPs, gold and managed futures as some of the least effective diversifiers. But historically, the exact opposite is true: MLPs, gold and managed futures have been some of the most consistent true diversifiers.

MLPs and gold tend to perform better when the prices of oil, natural gas and gold are appreciating. Managed futures strategies have the ability to benefit from either inflationary or deflationary environments because they’re structured with the ability to go long or short. What’s more, they seek premiums from the types of risk that could occur in many different economic environments.

To avoid being swept up in the complexity of the alternatives space, stay grounded in the basics: clearly define your goals, allocate to a basket of investments that take a variety of risks, and rebalance in a consistent, disciplined manner.

 

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