By Hans-Christian Winkler, CFP®
The last 100 years have been a whirlwind of change in literally every aspect of our lives, from technology and medicine to travel and the internet, to name a few. It would be unimaginable to do many things the same way they were done 100, 50 or even 30 years ago. The world of investing has not been immune to these changes and a tremendous amount of progress has been made over the years in how we can properly diversify our money into areas that were not available before. What used to be a viable investment strategy a few decades ago has become less effective and outdated. The modern-day investor needs to be aware of these changes and know what investment products and strategies are available today to create a properly diversified investment portfolio.
1960s-1970s: The Nifty 50
During this time when investing became more important to the American population, the Nifty 50 was a popular way to invest money. This strategy was essentially buying and holding stock in the 50 largest U.S. companies on the New York Stock Exchange. It was a long-term buy and hold strategy that was considered diversified for that time because you owned 50 different stocks. There were no financial TV channels like CNBC or Bloomberg to give you minute-by-minute updates of the stock market, the concept of trading stocks was almost unheard of, and Mid-cap, small-cap and international stocks virtually did not exist as investment choices.
With the influx of investment options available today, the Nifty 50 investment strategy is now obsolete and ineffective.
1970s-2010: Mutual Funds
Even though mutual funds were introduced to the U.S. in the 1890s, they did not become popular investment vehicles until the 1970s, when more and more companies started to list their shares on the New York Stock Exchange. Investing in mutual funds and bond funds was a huge advancement from the Nifty 50 times because it allowed investors to better diversify and also gain access to small and medium-sized companies.
With the help of the modern portfolio theory, which was developed by economist Harry Markowitz and won a Nobel Prize in 1990, investors were better able to develop investment portfolios based on their investment objectives, risk factors and time horizons, and could achieve "full diversification” among large-cap, mid-cap, small-cap and international stocks and bonds. At this point investors were able to put money into virtually every corner of the stock and bond market, and therefore better spread out their risk.
Even though this was a very efficient way to invest money, one of the downsides has always been that investment returns are only as good as the performance of the stock or bond markets, which is great when markets go up, but problematic when markets become volatile or worse, produce negative returns.
2010-Present: Alternative Investments
Around 2010 a whole new investment universe, called alternative investments, became available to individual accredited investors (which, by definition, have to have a minimum net worth of $1 million outside of their primary residence or a yearly income of $200,000 for singles or $300,000 for couples.)
Alternative investments can be both private and public companies and range from real estate companies that build or operate multi-family homes, office buildings, triple-net-lease buildings, parking lots, student housing, industrial warehouses and retirement communities, to hedge funds, private equity and debt, venture capital firms, energy and natural resources, commodities, or 1031 exchange companies.
Even though alternative investments are relatively new to individual investors, university endowment plans started buying alternative investments in the mid-1980s and have a majority of their assets invested in them today. This specific shift in investment strategy has arguably made them the most successful and consistent investors during this time period. Family offices, which are advisory firms that serve ultra-high net worth clients, started to take notice of this trend over the last 20 years and today invest about 30%-40% of their money into alternative investments. Adding alternative investments to an investment portfolio effectively addressed the downside of only owning equities and bonds, because typically they do not fluctuate with the ups and downs of the stock and bond markets.
This strategy helped endowment plans and family offices to be less dependent on good market performance. In comparison, many individual investors today still have no exposure to alternative investments, which leaves them more vulnerable during market volatility and bear markets.
2018 and Beyond: Full-Spectrum Diversification
Alternative investments are not a short-term trend, but a more holistic and sophisticated strategy to properly diversify money. The investment portfolios many people still have today with an asset allocation of 70/30, 60/40 or 50/50 mix of stocks and bonds are now only partially diversified with the availability of alternative investments. To be fully diversified in today’s investment world, investors should focus on a 33/33/33 mix of equities/bonds/alternative investments, which would give them a great new balance and better diversification among all available asset classes.
The long-term benefits of alternative investments, when properly diversified and allocated, include:
- Lower stock and bond market dependence in your investment portfolios
- Lower portfolio volatility, which in turn could increase predictability to calculate future investment returns towards or during retirement
- Possible lower tax payments due to the availability of tax deferred distributions, long-term capital gains due to longer holding periods and even possible tax write-offs due to depreciation features of certain energy companies
However, investors should consider the following before investing into alternative investments:
- Many alternative products are considered illiquid investments, and money can be held with a company for three to seven years.
- It is recommended that alternative investments do not exceed 30% to 40% of one’s overall portfolio in the event unforeseen cash is needed and investments need to be liquidated.
- Investors should remain prudent and avoid allocating more than 5% to 10% to a single alternative investment company.
Alternative investment products are the result of the continuous advancements of the investment world and should become an integral part of your investment portfolio if possible. Consult with a knowledgeable financial advisor to determine your eligibility and for guidance through this full-spectrum diversification process.
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This article was originally published on Investopedia.