You’re no doubt familiar with the basic concept of diversification: A mix of asset classes—such as stocks, bonds and cash equivalents—can help smooth out volatility in your portfolio over time. But today’s climate is more challenging, says Tony Davidow, asset allocation strategist at the Schwab Center for Financial Research. “With a backdrop of higher volatility and slow economic growth, in my opinion, it really makes sense to expand diversification beyond the ‘core’ asset classes,” he says.
Years ago, owning different types of stocks may have seemed to provide adequate diversification. That’s less the case today, because the equity markets have become more correlated—meaning that different parts of the market tend to rise and fall at the same time. For instance, from 1995 to 2000, U.S. small-cap and large-cap stocks delivered moderately different returns, but today, their returns show a 0.92 (near-perfect) correlation. That trend has played out in the relationship between domestic and international stocks, as well, which is why diversification across asset classes makes more sense than ever. And it’s another reason to consider new or “nontraditional” asset classes for even greater diversification, Tony says.
There are many investments that fall under the nontraditional umbrella, so it’s important to bear your long-term goals in mind. But according to Tony—given the specific challenges of today’s market—there are certain nontraditional asset classes that many investors may be overlooking.
It may also be beneficial to think of investments based on the role they play in the overall portfolio. For investors looking to increase their income, they may want to consider high-yield bonds to supplement existing fixed income holdings, although they do come with increased risk. Certain commodities and TIPS (Treasury Inflation-Protected Securities) offer a hedge against inflation—which might be more of a concern in the future. For growth and income, REITs (real estate investment trusts) have the potential for better performance and dividend yields akin to stocks, plus a hedge against inflation.
Some investors may not view commodities as a desirable option, given their poor performance over the past two years, but Tony warns against “rearview mirror investing.” “People get stuck thinking of each investment in isolation—and judging its recent performance—rather than thinking about the role an asset has in the overall portfolio,” he says. Commodities, including oil and gold, have gone through periods of weak and strong performance. But the fact that they don’t correlate strongly with other asset classes makes them useful as diversifiers, he explains.
No diversification strategy can ensure a profit. And while some nontraditional assets carry extra risks, combining them in a well-diversified portfolio may actually help you better weather market volatility. And there may be other long-term payoffs, Tony notes. When you hold asset classes that have a low correlation with one another, you increase the potential for better long-term performance—with less risk—than if you’d invested in fewer asset classes. This is the cornerstone of Nobel Prize–winning economist Harry Markowitz’s work, which became the basis of modern portfolio theory.
Assess your portfolio to see which nontraditional asset classes you may want to add, but keep in mind that most should still be small percentages except in very aggressive portfolios. For example, Tony generally suggests an allocation of 5% or less in commodities or REITs for most investors.