Diversification involves spreading your investment holdings across various investments to help lower your investing risk, without necessarily sacrificing a lot of return. However, this approach works very poorly when there is high correlation among the asset classes, and therefore very little difference in the returns.
Alternative investments, which provide investors with exposure to a variety of nontraditional investing opportunities that were once a secret of the super rich, provide true diversity by funding offerings that are unrelated to traditional holdings; much like stocks and bonds for example.
According to analysts, investing in alternatives can function as the 1) core of an investor’s portfolio, 2) they can be included at the edges, or 3) they can make up the entire investment portfolio.
- At the Core: Using this approach, alternatives are at the “core” of the portfolio and comprise 50% to 80% of investments, with traditional holdings comprising 20% to 50% of the portfolio. Often this appeals to affluent investors who require a relatively predictable stream of income from traditional asset classes, but also possess sufficient wealth to go outside of the mainstream offerings.
- Sitting on the Edge: Using this approach, investors allot no more than 10% of their portfolio to alternatives, with the remainder of holdings invested in traditional assets. This is a recommended approach for the everyday investor who wants to stabilize their portfolio with nontraditional investments, but do not want to conduct a lot of investment research and due diligence.
- Going all in: Although only appropriate for a small percentage of more affluent, sophisticated investors, this approach involves the use of several different alternative investment funds to makeup the clients’ entire portfolio. Participants must possess the resources to be able ride out periods of low return, and be certain that their investments are properly diversified across different industries and regions.
Diversification is not just a matter of investing in different asset classes. It is also about diversifying the ideas and approaches that comprise the portfolio. With alternatives like real estate investments for example, there are fewer constraints and therefore investors have more flexibility to discover profitable opportunities, outside the realm of traditional investments.
It is also important to note that because strategies employed by alternative funds can take a longer period of time to deliver a return, investors with significant exposure to them must be patient.