It was the summer of 1968, two men were both invited to dinner at the home of Ralph Waldo Gerard, the dean of graduate school at University of California – Irvine. One of the men was a mathematician who beat Las Vegas and was now turning his attention to financial markets. The other, a humble Nebraskan who had amassed a fortune already at the age of 38 by managing his investment partnership since graduating from Columbia. The two men were Ed Thorp and Warren Buffett. Buffett pulled out a dice game and asked Thorp if he would like to play.
Buffett was testing Thorp to see if he was up to the task of taking over for him in managing the Gerard’s family money since Buffett was closing his investment partnership. Thorp, being a brilliant mathematician, immediately figured out that the dice Warren was playing with had “non-transitive” properties.
Much like the game of Rock, Paper and Scissors, we don’t know what the capital markets will throw at us. Various assets have unique behaviors during different economic regimes. Predicting future economic and market outcomes is one thing, profiting from them is another:
· Accurately forecast what events will occur = incredibly hard
· Accurately predict how human investors will react to those events = Good luck
Wise investors realize that they don’t have to play that game and focus on properly allocating portfolios to accommodate a wide range of outcomes. Still, many investors tend to over rely on just two asset classes – Stocks and Bonds. What if there was a third ingredient we could add to the pot?
First, let’s define what exactly qualifies as an alternative investment. To quote Phil Huber from his book The Allocator’s Edge, “The word alternative, regardless of the source of its use, tells you more about what something isn’t rather than what it is.”
“Pork bellies, which is used to make bacon…. which you might find in a bacon, lettuce and tomato sandwich….”
- Randolph Duke, Trading Places
Portfolio management is more about managing risk than it is about managing returns. Everyone knows the saying, “Don’t put all of your eggs in one basket...” If investors can find additional sources of risk and return beyond what stocks and bonds have to offer, it may be worth adding to the portfolio to smooth out returns over time.
The above visual illustrates that Portfolio 2 has a higher average annual return, but it comes at a price via higher annual volatility. Over the course of the5-year period, Portfolio 1 comes out ahead even though it’s annual average returns were lower!
The dark blue boxes represent a diversified portfolio of 40% stocks, 40% bonds and 20% alternatives. The blue box remains in the middle rows highlighting how diversification reduces volatility drag on an investor’s portfolio.
Data from AQR illustrates just how expensive traditional assets are still:
The shaded box illustrates that we are in a 4 plus decade period of stocks and bonds enrichening their valuations which only lowers future expected returns going forward. During this period, the simple expected real return of the 60/40 portfolio fell from above 6% to a trough of 1.3% at the end of 2021. Even after the carnage of 2022 where bonds lost 27% in real terms, the traditional 60/40 portfolio is still historically expensive! It is important to note that expected returns should not be usedto time markets and asset classes. Expensive assets can always become more expensive and stay expensive for long time periods.
“Markets can stay irrational longer than you can remain solvent.”
– John Maynard Keynes
Many who argue against adding alternative assets to a traditional stock and bond portfolio will point out how bonds have provided all the diversification one needs. Let’s take a closer look at that claim….
They’re right…. just for the last 20 years. Investors who extrapolate future risk and return of the 60/40 allocation based on recent performance may be drastically understating potential risk and volatility going forward.
· The 60/40 portfolio produced impressive returns in recent memory, but perhaps we should pump the brakes – do we think bonds can continue to perform on par with stocks?
· Bonds saved investors from stock market crashes from 2000-2021. 2022 has been a harsh reminder that this isn’t always the case as inflation and rising rates pummeled both sides of the 60/40 portfolio.
Not everyone needs alternative assets in their portfolio. Younger investors who are accumulating capital and investing for years to come can withstand long-term equity market declines. The case for diversifying stock market risk becomes more evident as one approaches retirement and begins to draw money from their portfolio. Portfolio drawdowns become more damaging and difficult to repair if capital is being withdrawn. The future recovery is lost forever as retirees distribute assets out of the portfolio to meet their living needs.
The graphic above is from AQR and highlights how a diversified portfolio of alternative strategies perform compared to the 60/40. The green shaded area left of middle axis shows when the traditional 60/40 stock and bond portfolio experienced negative returns. It is this environment in which alternatives can provide a positive asset class to distribute from.
Alternative investments can be attractive for retirees by offering a 3rd bucket to draw from during difficult economic periods when stocks and bonds are selling off. Retirees can’t choose what economic environment they retire in. Because of this fact, they should look to build a portfolio that is robust and durable to a multitude of economic shocks. By doing so, they can ensure that their savings can meet their retirement needs.
A simple checklist can help remove the bulk of alternative investments that should be avoided.
1. Returns must have no relation to stocks and bonds
2. Must be grounded in economic rationale and scrutinized academic research
3. Must survive transaction costs and management fees
4. Is accessible for common investors and provide relative liquidity
The same principles that apply to stock and bond funds can also be applied to alternative strategies to help avoid unnecessary risk, fees and underperformance.
Go with what you can stick with!
· The best diet plan = one you can stick with
· The best workout plan = one you can stick with
· The best golf swing = one you can stick with
· The best spouse = one you can stick with
· The best investment strategy = one you can stick with!
If an investor chooses to allocate a portion of his/her portfolio to alternatives, they must commit to it for the long-term. There is no investment strategy so great that it cannot be ruined by human reaction.
Disclosures: This article is for informational purposes only and should not be considered a recommendation. Information contained in this article is obtained from third party resources that Meredith Wealth Planning deems to be reliable. Consult with a financial advisor before implementing any strategies. Past performance does not equal future results. Meredith Wealth Planning does not guarantee any minimum level of investment performance or the success of any index portfolio, index, mutual fund or investment strategy.
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