Last week my partner and I participated in a webinar about alternative investment strategies -- different types of these, as well as how to position them in your portfolio. We also discussed the "endowment model," which tends to utilize alternative strategies. Take a look at the chart below -- the historical investment return of the company that manages the endowment of Harvard University. As you can see, it has achieved excellent performance.
So, how and why do we need alternative investment strategies? The basic reason for using these is improving the risk-reward profile of your portfolio -- that is, reducing your portfolio risk a great deal, while only paring back a bit on your potential returns.
However, the current investment environment is clearly not great -- the slow U.S. recovery, the uncertain political direction in Washington, the euro crisis and Middle East turmoil are all contributing to our anxieties and fears. The markets are quite unpredictable, with high correlation among assets and geographies, and high volatility. What we want and need is some safety. We certainly don't want a repeat of 2008, which saw folks losing their returns and their principal. As Mark Twain famously said, "The return of my money is more important than the return on my money."
How do we achieve this? First, let's look at where returns come from. It is well known that investment decisions by managers, in the terms of stock selection and timing, does little to improve performance, and can actually hurt performance over the long run.
In fact, according to an influential study by Gary Brinson, Randolph Hood and Gilbert Beebower, stock selection and market timing do not matter nearly as much as how one mixes the building blocks of an investment portfolio. They concluded that asset allocation, and not stock selection, explained more than 90% of investment returns. Although the study has been controversial, the authors are clear that market timing and stock-picking actually decrease portfolio returns. In other words, the key to a winning investment strategy is not so much choosing the right investment or deciding on the best time to buy or sell. Rather, it's choosing the right asset mix and then sticking to it.
However, we need to improve on the classic portfolio allocation of 60% stocks and 40% bonds. A typical modification is including international stocks and bonds, including those from emerging-market countries. This brings out better diversification, and brings us closer to an improved risk-reward profile, but it is not enough.
Beyond this, we should divide the portfolio into what I call asset categories. These include financial assets, or stocks and bonds; physical assets, or consumable assets, such as commodities; and hard assets, such as real estate, art and other tangible items that last a long time. There's also "other equity" -- or private equity and venture capital fund.
A final category is alternative assets, which are absolute-return, hedged and long/short strategies. The reason these strategies help us achieve a better risk-reward profile is that they lower volatility, and they generate returns that are uncorrelated to the major indices. The investment objective of these funds is to earn cash-like returns of several hundred basis points.
Instead of the old 60-40 split, then, I would recommend allocating 50% to financial assets (including domestic, international and emerging-market stocks and bonds), 10% to physical assets, 10% to hard assets and 10% to "other equity." The remaining 20% could be allocated to hedged strategies.
If you dig deeper into allocations that Harvard has in its portfolio, you will notice the faster-growing asset category is "absolute return." While most of the asset categories have been reduced, the absolute-return allocation has been bumped up by 30% since 2005 -- from 12% to 16% of the portfolio.
If you follow this type of portfolio-allocation scenario, you will diversify your portfolio, thereby reducing risk -- and, in these uncertain times, perhaps you will sleep better at night.
This article originally appeared on ETF Profits.