Originally published by Forbes on December 22, 2023
In the era of investment democratization, opportunities are endless for individuals to access a diverse array of financial products. While ETFs led the wave in the 1990s, the past decade has brought access to an ever-growing list of alternative asset classes from private companies to private credit, wine, cryptocurrencies and more.
As we approach 2024, I hope to help answer the question on every investor’s mind: How do we navigate this sea of options and build a broadly diversified portfolio that stands resilient in today’s market?
The Power Of Diversification
While picking the “right” stock or cryptocurrency is alluring, investors’ primary focus should be asset allocation, with the aim of striking a balance between risk and reward characteristics across various asset classes. A well-diversified portfolio encompasses allocations to low-risk assets like treasuries, alongside equities, bonds, commodities and alternatives. The goal is to prevent any single asset class from unduly influencing overall performance, either positively or negatively.
Some may argue that in today’s macroeconomic environment, investors should park their money in treasury bills for a seemingly risk-free return, diversification be damned! But forward-looking investors recognize the limitations of such a strategy. There is a lot of speculation about where rates will end up in the coming year, and your guess is as good as mine.
Furthermore, since “everyone” is investing in treasuries, they have become relatively expensive, making it hard to buy low and sell high. Meanwhile, other asset classes like alternatives have become cheaper, especially as valuations have corrected. While different asset classes will outperform in different market environments, timing the market to get into an asset class before others is harder than ever. In the age of X/Twitter and high-frequency trading, the time advantage may be hours or days, not weeks or months. Because of this, long-term strategic asset allocation trumps tactical moves, and a balanced portfolio demands a thoughtful blend of diverse assets to weather the storms of fluctuating market conditions.
While the media often glorifies concentrated investment success stories, the reality is that most investors lack the resources and experience to successfully emulate such strategies. We can’t all be Warren Buffet after all. This is why diversification across various assets remains a prudent choice for most investors. It offers a more achievable approach to mitigating risk and seeking consistent returns.
Optimizing Risk And Reward
When investing across a diversified portfolio, investors can optimize by doing one of the following: reducing risk or increasing reward (return). When rates were low, like in the pre-2022 era, investors needed to take more risk to get a certain reward. This created an investment environment that maximized reward.
As we all know, times have changed and rates have increased. Because of this, investors should now focus on minimizing risk, rather than maximizing reward. One way to minimize risk in a high-rate environment is to minimize exposure to rate-tied strategies within the alternative asset allocation of your portfolio. This includes personal credit and loans, real estate, high-yield investments and other assets that are directly tied to rates. Fixed-yield investments can quickly underperform in a high-inflation environment, creating portfolio risk.
Investors should instead focus on “equity-style” alternative products where the underlying asset is more like a stock than a bond. These investments tend to be resilient in higher inflation environments by striving to provide asymmetric upside.
When it comes to picking equity-style alternatives, investors should look for assets with underlying fundamental value. Farmland, timber, private companies and music royalties are a few examples that fall in this category. They all produce an underlying yield, whether that is cash flows in the case of a company, hard assets in the case of farmland or royalties that can fuel portfolio growth. While there are many inherent benefits to these types of investments, it’s important to note that they also come with risks. Investors must still conduct proper due diligence and understand the risks when considering these or any other investment option.
Conversely, investors should be wary of alternative assets where the upside hinges purely on asset appreciation. This includes art, wine, collectibles and other assets where there is no inherent yield, and instead returns rely on a future buyer hopefully willing to pay a higher price. In a risk-off market environment, investors should invest in alternatives with fundamental value rather than speculative, lottery ticket investments.
Building Exposure To Alternatives
Unlike equities, there’s no one-size-fits-all ETF for a diversified allocation to alternatives. However, investors can explore diversified fund offerings, like those focused on private companies, to construct a well-balanced alternatives allocation. The specific allocation will look different based on a given investor’s personal goals and investment time horizon. Someone retiring in 10 years should allocate differently than someone in their 20s just beginning to invest.
Regardless of specific allocation size, all investors should consider an allocation to alternative investments in their portfolio. As we enter 2024, some investors may need to increase this allocation if the value of their alternative investments holdings have shrunken.
While I can’t tell you what 2024 will hold for the markets, proactive investors should review their holistic asset allocation strategy, especially when it comes to alternatives. This effort is much more effective than trying to time the market or picking individual stocks. In a landscape characterized by high rates and rate uncertainty, the prudent move is to hold a diversified portfolio and reduce rate exposure. Investors will be wise to not ignore equity-style alternative assets to navigate the challenges and opportunities that lie ahead.
Diversification does not assure a profit or protect against market loss.The information provided is for general informational purposes only and should not be considered a recommendation or personal financial planning, tax, rollover, or financial advice. The information provided should be used at your own risk
