January 19, 2021
How Alternative Investments Can Help Diversify Your Portfolio
Diversification is one of the central tenets behind crafting a robust portfolio. How you choose to diversify can make a major difference for growth in good markets and resilience in volatile ones. The truth is that diversification in the stock market alone only provides so much protection or upside—and that’s if you’ve built the right kind of diversification in the first place.
Nearly every investor has some percentage of their portfolio wrapped up in stocks. After all, stocks are the primary value generator in one’s assortment of investments. Having too much direct exposure to the stock market, however, means exposing yourself to greater losses. But by making sure other, more historically stable investments have a place in your portfolio, you can help offset unrealized gains.
There are many ways to diversify your portfolio. Moving allocations from stocks to mutual funds and ETFs can mitigate your exposure to company-specific downturns, but may still leave you vulnerable to sector-wide losses. Bonds may underperform when interest rates are low, leaving you with little opportunity for meaningful gains.
This doesn’t give investors many viable diversification options that also have the potential to deliver meaningful value. Merely leaving one’s assets in a low-interest bond isn’t an appetizing option for anyone who wants to still avail themselves to upside in a tough market. In order to seize on real investment opportunities, one has to look toward diversifying through alternative investments instead.
Alternative investing has become a popular portfolio staple for many. As of 2019, 23 percent of investors surveyed were said to include alternatives in their portfolio. Only 7 percent of investors had alternatives in their portfolio two decades prior. New alternative investing platforms make it easier to pursue opportunities beyond the stock market. Better yet, there are several diversification opportunities within the world of alternative investments as well. Each offers something different, making it crucial to know everything about diversifying into alternative investments before you begin.
When you pick the best alternative investments to help you diversify your portfolio, you’re helping to protect your assets while also venturing into new markets. Here’s what you need to know about common diversification tactics, missteps, and opportunities within the world of alternatives.
Why Diversification is Essential in Today’s Market
Portfolio diversification is a must in any economy. In a bull market, diversification avails you to gains across several sectors, which can create significant value. During periods of market volatility, a balanced portfolio can help you weather the storm more easily. And, depending on your investing goals, a diversified portfolio can even help create steady returns over a certain period of time.
If you’re like most investors, the majority of your portfolio likely consists of stocks. Stock holdings tend to be considered the riskiest kind of asset in one’s broader portfolio. When markets perform well, having direct stock ownership means you get to reap the rewards. When markets are in flux or on a downswing, you’re left to roll with the punches of a stock that’s lost value. This is unlike investment funds, which often reallocate their underlying investments to mitigate these kinds of losses.
That’s why it’s crucial to balance your exposure to the market through other means, such as investment funds, bonds, and alternative investments. One recent study concluded that a balanced portfolio consisting of US stock, foreign stock, bonds, and short-term investments could provide an annual average return of almost 8 percent, based on historical stock performance. This means that a well-balanced portfolio doesn’t just help you avoid losses and risk; rather, it can also drive value that you may not have gotten otherwise.
With market volatility on the rise, diversification has become more crucial than ever. The market swings more dramatically than it has in years’ past. The COVID-19 pandemic’s economic toll on global markets has led to several swings of 1,000 points or more, which can wreak havoc on one’s portfolio on a monthly basis. For example, the travel and hospitality sector experienced a nosedive during the first half of 2020. If your portfolio was too heavily invested in this area, odds are you’d be in for significant losses in the short- to medium-term as a result. On the other hand, if you incorporated remote computing or video conferencing company stock as part of a broader portfolio, you would be able to benefit from gains in this area—offsetting losses you might have sustained elsewhere, like in airline stocks.
Simply spreading your money across an assortment of stocks, bonds, and funds won’t cut it, however. There are certain methods and mathematical factors that make the difference between true diversification and well-intentioned—but incorrect—methods of spreading assets. Many investors end up “over diversifying,” which is when a portfolio actually stops adding more risk protection and increases the chance of lowered returns on your investing dollar. Plus, if you end up diversifying into market sectors, industries, and businesses you’re not familiar with, you’ll have a much harder time reading trends and making sure you’re putting your hard-earned money into the wrong asset.
Common Diversification Pitfalls
Your average investor knows that diversification is important, and has likely considered ways in which they can diversify. What few realize, however, is that not all attempts to diversify actually work. In fact, some may even do more harm than good.
Stock diversification is more of a challenge than it might appear. After all, stocks are more volatile than other investment types, making the margin for error slim. Stock diversification is often mistaken for buying a ton of different stocks. This is far from the case, however. In fact, one landmark study found that larger investments in a handful historically well-performing stocks generated a better return than a portfolio composed of a wider variety of stocks.
There are right and wrong ways to diversify your stock holdings as well. Expert advice suggests most investors hold no more than 30 stocks in their portfolio, lest they be spread too thin and end up diluting returns. Adding stocks into your portfolio just for the sake of diversification means investing dollars into something other than your top-tier holdings. In this sense, diversification only serves to add bulk to your portfolio, rather than value or safety.
Other asset classes, like investment funds or bonds, may not be as flashy as stocks, but add slow and stable growth. This can serve as a bulwark against stock-related losses, and can also create long-term growth for your portfolio. This takes some of the pressure off your stock holdings to perform consistently, lest your portfolio lose significant value over time.
As with stocks, there are a vast assortment of different investment funds available. And, much like with stocks, some investors end up holding on to too many overlapping funds. This may result in you owning the same underlying properties in two different funds. This could either happen by accident—if an investor doesn’t look at underlying assets for overlap—or through a misguided attempt to diversify holdings in a certain market segment or sector.
Overlapping funds can actually rob you of returns in the long-run. If you participate in two mutual funds that invest in the same stock, you’ll end up paying a manager’s fee twice for the same return. This erodes your gains unnecessarily, which means leaving value on the table (or, more accurately, a fund manager’s pocket).
Bonds are also included in common diversification strategies. Bonds give investors a guaranteed interest rate in exchange for their investment over a predetermined period of time. Depending on the bond (and the issuer), this investment can be among the safest available. Bonds don’t come with the same day-to-day fluctuations as stocks, and can serve as a stable place to park one’s stock earnings during a down market.
Bonds are not perfect, however, and should play an ancillary role in your diversification strategy. For starters, bond rates are at significant lows right now. This means investors aren’t likely to make a meaningful return on their investment. Even in high-interest periods, bonds still have potential downsides, such as delivering less of a return than the market average. Bonds are one of the least volatile options out there, but it’s far from the only one.
How Alternative Investments Can Help Diversify Your Portfolio
You can only diversify so much through the stock market, funds, and bonds. This kind of diversification may set you up to take advantage of market trends and mitigate some of your risk of lost value, but not nearly enough. If your assets are still tied up almost exclusively in the market, you’re not maximizing your diversification options. That’s where alternative investments can help.
Broadly defined, alternative investments are any kind of investment that isn’t in stock, bond, investment fund, or cash. This is just the tip of the iceberg in the world of alternatives: other options include more exotic investments like artwork, rare coins, or fine wines. If you’re new to alternative investments, it’s better to stick with some of the more conventional options though.
With alternatives, you can invest in a host of assets that appreciate in ways that aren’t directly pegged to market moves. This is known as “low correlation,” meaning that alternatives do not typically rise or fall in value when stocks do. Having several low correlation assets within your portfolio helps preserve value in the event that stocks lose value, and many alternative assets enjoy a significantly low correlation value. In other words, alternatives can buck market trends.
The multitude of alternative investment types and options are at the core of why they can play a meaningful role in diversifying your portfolio. Some alternatives are geared toward stability and slow, steady growth. Other alternatives permit investors to take on more risk in exchange for a heftier return than market averages. No matter what your risk appetite is, there’s an alternative investment out there to help you spread your assets out wisely.
Alternative Investment Opportunities for Diversification
The world of alternative investing is vast. Some alternatives, such as real estate or precious metals, are well-known options for your average investor. Others might be a bit more niche, such as fine art collecting or investing in rare wines. There are plenty more that are somewhere in between these two extremes, which can offer investors with a low correlation investment opportunity that still plays a clear role in your overall portfolio.
Gold and Precious Metals
Gold and silver are perhaps the most well-known alternatives around. Both hold value well and have a low correlation with stocks, which means they offer a significant diversification opportunity when stock performance is sluggish or unpredictable.
Plus, precious metals as an asset class can offer investors a hedge against market downturns, as gold in particular has a lengthy history of retaining its value—or even increasing in value—during periods when markets are sluggish.
In fact, gold has an inverse relationship with the ups and downs of the markets. When markets are down, the gold prices tend to increase. For example, the S&P 500 lost half its value from December 2007 to February 2009, while gold rose by 14 percent during the same timespan. This makes gold a great asset to include in your portfolio—be it during turbulent financial periods or periods of calm.
Be aware that getting into gold can come at a premium due to its stability: the price of gold per ounce increased by almost 25 percent in 2020 with an average closing price of $1,393.34. That means investing in gold isn’t cheap, and you’ll have to put a fair amount of money into even a small position. Part of gold’s expense is due to its popularity, which has sent it soaring in recent years. Gold can help you diversify, but investing in it may require you to put a few too many eggs into one golden basket.
Commodities are another common option for alternative investors seeking to branch out of the stock market for diversification. Agricultural commodities are vital elements of the economy as well as society itself. Because commodities are so important, they also make for a good alternative investment opportunity. Prices tend to stay consistent so long as supply and demand are balanced. When inflation strikes, agricultural prices tend to increase. This provides an excellent hedge against stock market losses.
The overall value of the American agricultural industry in 2019 was $1.109 trillion when measured in terms of gross domestic product. The sheer size of this economic sector makes it an alluring option for alternative investments. Bear in mind that commodity prices can fluctuate depending on a host of factors, such as changing consumer demand and oversupply.
Real estate can offer investors a unique opportunity to diversify their holdings that may do more than just keep you from putting too much capital in one or several sectors. Real estate value, particularly in areas where property is in high demand, can net you gains that exceed what you’d get on Wall Street.
There are a host of ways that investors can get into real estate. The most obvious is home ownership, particularly if you’re purchasing a home or plot of land for the sake of renting it. The same holds true for development: be it building a home or commercial property. You’ll be able to pull money out of the market and build a passive income stream all the while.
Investors can also participate in a real estate investment trust, which allows participants to own fractions of a property that is managed through a trust. REITs make it easy to invest in real estate without having to take on any of the challenges of being a landlord or developer.
Bear in mind, however, that real estate can be a fickle investment, depending on where and when you invest. Real estate markets can be fickle and investment properties may be more expensive to repair or maintain than you might have expected. If you’re interested in real estate that doesn’t come with those challenges, enjoys steady land appreciation, and makes it easy for you to get started, then farmland investing may be a superior option for you.
Farmland investing is a unique alternative investment option as it combines the best of these three alternatives, as well as others. When investing in farmland, you’re given an opportunity to purchase shares of a working farm. You can then reap the rewards of the farmland’s value as well as the sale of its crops. This provides some of the same exposure as real estate and agricultural commodities combined. Plus, farmland has a track record of maintaining value, making it comparable to gold in terms of resiliency.
The need for food, and the farmland from which it comes, is set to increase. The entire value of U.S. farmland, as well as related buildings, capped out at roughly $2.7 trillion in 2018. Investing in farmland, particularly with an organization that takes the heavy lifting out of getting farmland in your portfolio, offers fantastic diversification. Farmland value isn’t tied to market fluctuations, and crops can even stand to benefit from inflation and market volatility.
When you invest in farmland, you have the ability to generate potential gains from a variety of sources—all without having to put money into a series of different alternative investments. Investing in farmland with FarmTogether also makes it easy to get started: all you need to begin is $10,000 and an account. From there, our team of experts will help guide you through the investment opportunities currently available. You can use our intuitive web platform to track your investments over time, and can contact us with any questions you might have along the way.
The Bottom Line on Using Alternatives for Diversification
For many investors, crafting a well-balanced portfolio goes beyond holding stocks and bonds. Alternative investments can offer more exposure to holdings that aren’t as dependent on overarching stock market trends. This can help reduce the risk of assets losing value when the market is sluggish. Better still, it can also avail you to new opportunities for growth as well.
Farmland can be a great fit for investors looking for diversification through alternatives. FarmTogether makes it easier than ever before to get into the world of farmland investing as well.
Disclaimer: FarmTogether is not a registered broker-dealer, investment adviser or investment manager. FarmTogether does not provide tax, legal or investment advice. This material has been prepared for informational and educational purposes only. You should consult your own tax, legal and investment advisors before engaging in any transaction.
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