The key to risk-adjusted returns and diversification is not the number of securities – it’s their correlation – or, really, non-correlation – to each other, that’s paramount to a portfolio’s risk-return efficiency.
The key to using alternatives is similar to diversifying with any asset class. Start with the end in mind, considering your portfolio objectives and risk tolerance. When considering alternative asset classes and strategies, understand that your choices are almost as varied as they are for stocks and fixed income.
Market Realist – Alternatives improve your portfolio’s risk-adjusted returns.
Let’s consider the correlation between stocks, bonds, and commodities. They’re alternative investments. The graph above shows the correlation coefficient of equities as tracked by the S&P 500 Index
(SPXL) (LLSP), bonds as tracked by the iShares Barclays Aggregate Bond Fund
(AGG), commodities as tracked by the Deutsche Bank Liquid Commodities Index, and spot gold with one another. It considers weekly returns over the last ten years.
As expected, the correlation between stocks and bonds is quite low at +0.04. However, adding commodities to the picture gives you great diversification benefits. The correlation between equities and gold is about +0.02. This is close to ideal. The correlation between bonds and gold is +0.06. So, gold behaves differently from both stocks and bonds. It helps reduce portfolio volatility (VSPY).
The correlation between stocks and commodities is slightly higher at +0.38. The correlation between commodities and bonds is -0.01. Also, most commodities tend to move differently. As a result, when you have stocks, bonds, and commodities in your portfolio, the risk-adjusted returns tend to improve. They move in different directions at different stages.
For example, in a risk-off scenario, stocks (SPUU) would fall, but bonds would cushion the impact of the stocks’ fall. In a high inflation environment, bonds would take a hit while commodities outperform. This is an example of how adding alternative investments to your portfolio can help diversify your portfolio. However, the asset allocation depends on how much risk you can stomach.
Read Is It Time to Buy Commodities? for more on alternative investments.
