The case for alternatives in your portfolio

While there are many ways to build wealth, most people are taught to do so through exposure to three asset classes. These are Personal Real Estate and a traditional portfolio of Stocks and Bonds. All of which have positive expected returns over time.

When building a portfolio, the rational goal is to capture the highest possible return with the least amount of volatility. Over time this led to the traditional balanced portfolio comprised of Stocks and Bonds.

Why? Simple.

Stocks and Bonds both have positive expected returns over time and historically have low correlation. Meaning they behave differently. Owning both asset classes will reduce the volatility of just owning one or the other. This is key because if one asset class is experiencing volatility the other may be behaving well, thus reducing overall volatility.

Notice I wrote may be behaving well. Low correlation is not negative correlation. Stocks and Bonds are not bicycle pedals (suggesting if one is up the other must be down). From time to time Stocks and Bonds can and will misbehave simultaneously. For example, Q4 2018 and most recently calendar year 2022.

Considering the use of Alternatives is no more complicated than introducing an additional asset class with positive expected returns to the portfolio. Specifically, an asset class that has low correlation to Stocks and Bonds.

At the risk of repeating myself, diversification into additional asset classes with positive expected returns and low correlation helps us compound wealth more reliably and with less volatility over time. In a thoughtfully deployed portfolio, this, almost by definition, reduces volatility and enhances expected return. Considering the use of Alternatives in a portfolio is a rational thought exercise.

What are Alternatives? This is a big question with a broad definition. I will suggest they are investments that behave differently from traditional stocks, bonds, and cash. Depending on your goals they can be used to introduce passive income to a portfolio, stability, growth, or all of the aforementioned at the same time. A few examples are investment real estate, infrastructure, commodities, private debt, private equity, leverage, and option strategies.

Historically, many of these Alternatives were gated behind Accredited Investor rules and out of reach for individuals below a certain net worth. As an advisor I found this troubling as it essentially created a two-tier investment landscape that, to my mind, exacerbates inequality.

Due to changes in the regulatory landscape in recent years as well as Eligible Investor rules for investors getting advice from a licensed advisor, we can and do execute these strategies for more and more clients.

In your personal wealth journey, you may reach a point where you are interested in bringing more sophisticated wealth building, income, and preservation strategies to your portfolio – or simply a little additional diversification to reduce volatility. There is expertise and track record in this space at PBD Wealth Management.