By Bill Dolan, Senior Portfolio Manager
In the wealth management industry, we define alternative investments as any investment asset, other than stocks, bonds, or cash. So, obviously, this is a pretty broad category and can often mean different things to different people.
Let’s take real estate, for example. Since real estate is not stocks, bonds or cash, it is classified as an alternative investment in our industry, but to many people, real estate is even more familiar than stocks or bonds and, therefore, seems every bit as traditional. However, for purposes of our discussion, we will stick with the framework of stocks, bonds, cash, and everything else, or alternatives.
Some other examples of investments that fall into the alternative investment category are private equity, hedge funds, precious metals, commodities, and private debt.
With the recent turbulence that we are seeing in the markets, it’s consequential to consider the role alternative investments can play in a portfolio that includes stocks and bonds. This role, of course, is to generate strong returns and diversify risk (lower risk) in the portfolio. This can be accomplished by including investments that don’t share the same risks as the other investments in the portfolio.
Investments have risk and that is why as investors we get a return, or compensation, for taking on risk. Risk comes in many different forms. Like the ancient Chinese merchants who didn’t put all of their goods on one ship when trading, but rather spread out their wares onto multiple ships to protect against potential loss, investors today are well served by spreading their risk among various investments. This is the part that may not be intuitive, but adding a risky investment to a portfolio can actually lower overall risk of the portfolio if its risks are different than those of the other investments
– while, at the same time, offering the potential for higher returns.
This is the appeal of alternative investments, and it works if you can identify and gain access to investments whose risks are truly different and not shared with the other investments in the portfolio.
Think about stocks and corporate bonds, where traditionally advisors would balance portfolios using these investments thinking they were diversified. But, as we saw during the financial crisis of 2008 and 2009, this diversification didn’t hold up, and that’s because publicly-traded stocks and corporate bonds share many of the same risks and the values of these investments went down together.
If you had an allocation to (or a portion of your portfolio in) investments that had different risks, like currency exchange rates or reinsurance that’s linked to natural events, or investments that make money when markets decline, you were likely to fare better and buffer the severe losses experienced by many investors during this time. By reducing the volatility and lessening the level of losses, your portfolio had less ground to make up and your wealth grew more.
For these reasons, along with where we are with the current interest rate environment and equity valuation levels, an allocation to alternative investments is becoming increasingly important in the pursuit of investment objectives and effective management of risk.
William “Bill” Dolan is a Senior Vice President, Senior Portfolio Manager, and a Team Leader for the Wealth Management Division at First Bank. Possessing more than 20 years of experience in multiple disciplines, including investment management, wealth management, and real estate investments, Bill is responsible for the overall development and coordination of wealth management activities for his team.