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Asset Classes to Consider for Deeper Diversification

Today's market presents new challenges.

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.

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Over the past couple of decades, the correlation between different types of equities has been growing.

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.

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Twenty years ago, diversification could be accomplished with three basic asset classes; today, your portfolio may need a more sophisticated approach.

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.

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Because commodities like gold and oil typically don&#039;t correlate strongly with equities, they can add diversification to your portfolio.

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.

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The hypothetical risk/return profile of $100 invested from 1970 to 2015 in large-cap equities (S&amp;P 500) and in commodities (S&amp;P GSCI) versus a 90-10 (equities-commodities) blend.

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.

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Here&#039;s what you can do next.

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.

 

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Important disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification and asset allocation strategies do not ensure a profit and do not protect against losses in declining markets.

Past performance is no guarantee of future results.

Investing in REITs may pose additional risks such as real estate industry risk, interest rate risk and liquidity risk.

Commodity-related products, including futures, carry a high level of risk and are not suitable for all investors. Commodity-related products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions, regardless of the length of time shares are held. Investments in commodity-related products may subject the fund to significantly greater volatility than investments in traditional securities and involve substantial risks, including risk of loss of a significant portion of their principal value.

Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the U.S. government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the interest amount payable is also impacted by variations in the inflation rate as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the U.S. government and may be adjusted for inflation to become the greater of either the original face amount at issuance or that face amount plus an adjustment for inflation.

Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly.

The S&P 500® Index is a market-capitalization-weighted index comprising 500 widely traded stocks chosen for market size, liquidity and industry group representation.

The Russell 2000® Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index, representing approximately 10% of the total market capitalization of that index.

MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the U.S. and Canada.

The MSCI Emerging Markets Index is market-capitalization-weighted index that tracks stocks domiciled in emerging markets countries.

The S&P GSCI® (Goldman Sachs Commodity Index) is a world production-weighted index comprising the principal physical commodities that are the subject of active, liquid futures markets.

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