The Alternative Portfolio: Diversifying Away From a Traditional Allocation
“How can I construct a portfolio that is capable of producing returns different than those of the S&P 500 and long-term Treasuries and that is also capable of warding off the threat of inflation?” This is what many AAII members have asked me for.
The good news is that I was able to create such a portfolio. In fact, over the time period tested, its performance topped that of a traditional large-cap/long-term bond portfolio. The portfolio can be replicated using exchange-traded funds. Unfortunately, this alternative portfolio is more volatile than a traditional portfolio comprised of large-cap stocks and long-term bonds. Furthermore, the time period used to test the portfolio may not be long enough to show whether its performance advantage will last well into the future.
In this article
- It Starts With Correlation
- The Basic Rules
- Creating an Alternative Portfolio
- Testing the Diversification Benefits
- Portfolio Performance
- Invest in Alternative Assets or Not?
- Past Journal Articles on Alternative Investments
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The alternative portfolio does complement a more traditional portfolio. It includes a mix of assets that provide diversification benefits to a traditional portfolio and enhanced returns over the time period studied. The benefits come at the cost of increased volatility, however. Thus, the alternative portfolio’s best use may be as a supplement to, rather than as a replacement of, a more traditional portfolio.
It Starts With Correlation
One of the most basic building blocks for any portfolio is correlation. In terms of investing, correlation shows how similar the returns of two asset classes are. Correlations of, or near, +1.00 imply that assets experience the same type of return characteristics. Correlations of, or near, –1.00 imply that assets tend to have completely opposite return characteristics. Correlations of, or near, 0.00 imply that the assets have different return characteristics. Two assets with a correlation near +1.00 will typically move in the same direction and will experience similar magnitudes of change in price. Assets with correlations near 0.00 will have different returns: As one asset moves up in price, the other may move up in price, move down in price or stay unchanged. There is no relationship between the return characteristics.
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