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The Benefits of Diversification

14Diversification is one on the most time-honored strategies for investors. Most everyone can see the benefit of “spreading out risks” or “not putting all your eggs in one basket”.  The traditional model for diversification has involved using three broad asset classes:  stocks, bonds and cash.

These broad categories are made up of various sub-classes that change over time.  Within stocks the simple breakdown of domestic/international has expanded to include categories like small company and emerging markets.  For bonds, the investment realm has moved past treasuries and corporate bonds to new strategies focusing on high yield, foreign and convertibles.

Modern Portfolio Theory, which has been used by portfolio managers for over 60 years, holds that diversification among asset classes will increase returns over time. The problem today is that bond yields have been driven so low by the Federal Reserve’s efforts to keep borrowing more affordable. We do not see interest rates increasing any time soon. When interest rates do begin to rise, the value of the bonds in your portfolio will decline. This, at least in the short term, will be hazardous to your financial health. So we find ourselves today in the unenviable position of not only earning very low returns on bonds but also facing price declines of the bonds we now own.

What are Alternative Investments?

In the past few years a fourth asset category, Alternatives, has received a lot of attention.  “Alternatives” is somewhat a catch-all term for strategies that do not fit neatly into the traditional three asset classes.  Some examples of the more common alternative strategies include:

Real Estate: This can include mutual funds that invest directly in real estate or those that invest in Real Estate Investment Trusts (REITs).
Commodities: This ranges from a one commodity strategy like gold to a broad-basket of commodities.
Long/Short: These strategies usually sell short one group of stocks to buy another.
Hedged: Generally this involves buying and selling futures or put and call options as a way of protecting the portfolio and possibly earning extra income.
Tactical (Unconstrained): These funds usually have the flexibility to invest anywhere and use virtually any investment strategy.

Negative Correlation is a Positive for Your Comfort

In finance, correlation is the statistical concept of how much two investments move in tandem.  The primary diversification benefit of alternative investments is they often have little or no correlation to traditional asset classes.  In some situations they may have negative correlation, which is highly desired for diversification purposes.  Over time this helps make a portfolio less volatile.

The past ten years has taught us that even the ride in a balanced portfolio can be very bumpy. Adding Alternatives to any portfolio will smooth the ride and make you more comfortable when that next inevitable market crisis occurs. Many folks today are embracing index mutual funds and ETFs. Alternative investments added to an indexed portfolio are especially important.

Wealth Preservation

At Meridian we have been actively adjusting your portfolio over the past two years to include Alternatives.  One of our favorites is the PIMCO All Asset All Authority Fund managed by Robert Arnott.  This Tactical fund takes full advantage of having few investment constraints.  The fund uses other PIMCO funds to invest long and short in stock and bond markets all over the world.  The end result is a fund that has had rolling 5-year returns consistently ahead of the S&P 500 with much less volatility and almost no correlation.

With the stock market at an all-time high and interest rates at historic lows, we expect to continue using these kinds of strategies as part of our focus on wealth preservation, not just growth.