In this episode of “Investment Management Foundations,” Gary Quinzel, Wealth Enhancement Vice President of Portfolio Consulting, discusses how you may be able to diversify your portfolio with alternative investments.
VIDEO TRANSCRIPT BELOW
Welcome to this episode of “Investment Management Foundations.” My name is Gary Quinzel, Vice President of Portfolio Consulting. Today's topic is adding alternatives for portfolio diversification. You know, one of the best ways that you can help optimize a portfolio is by considering adding alternative investments to the traditional portfolio of stocks and bonds. You may be wondering to yourself, “What does that mean to optimize the portfolio? And why do risk adjusted returns even matter?” So, we've stepped back in time. Back in 1952, an economist by the name of Harry Markowitz wrote a paper called Portfolio Selection that eventually won him a Nobel Prize in Economics four decades later. The key takeaway from Harry's paper was that a diversified portfolio is far less volatile than the sum of the individual parts. And this evolved in something called Modern Portfolio Theory, which continues to be one of the driving principles behind portfolio construction today, and it really has such an amazing impact on everything we do as investment practitioners.
Market Portfolio Theory allows investors to assemble a portfolio of assets that helps maximize the expected return of a portfolio for a given level of risk. And the reason I bring this up is because, as investment practitioners, we use Market Portfolio Theory to establish an efficient frontier, which is basically a curve graph that goes from the lower left to the upper right if we plot different investments on the scale of volatility on the x axis, the bottom axis, and expected return on the y axis, or the left axis. And we do this in order to optimize the expected return of our portfolios, given investors level of risk.
Okay, so that was a little academic. And let me explain why this matters to investors. Well, normally, most retail investors typically only invest in what's familiar, and stocks and bonds are the most widely known and widely available instruments that are available to retail clients. But institutions, endowments, foundations, pension funds, etc. figured out a long time ago that adding alternatives to a portfolio that's already diversified in stocks and bonds is a great way to move the expected risk-adjusted return up into the left, as this graph demonstrates. And when I say up and to the left, what we're essentially meaning is based upon the portfolio's expected volatility, we can actually forecast that over time, it should have a higher risk-adjusted return.
And now, there's many different alternatives to think about. There's everything from private equity, private credit, hedge funds, real assets, and many iterations in between. The key to investing in alternatives is to have a diversified mix of alternatives that help your individual objectives and set and satisfy your individual risk tolerance or requirements. As this chart demonstrates, a 60/40 client, for example, can go on to something like 30/40/30, and many, many other iterations. So, there's really no one solution that’s best fitted for clients.
I think the key takeaway here to remember is that, you know, portfolios can be optimized in the sense that by adding additional strategies that have low volatility and low correlation to one another, we can actually lower the overall volatility of the portfolio and help increase the odds of having lower volatility and higher risk-adjusted returns over the long run. Admittedly, alternatives are not right for everyone. There's a lot of considerations, such as potentially higher fees and less liquidity and lockup periods over time, and those should be talked about with your financial advisor. But we think that for many clients who are looking to lower their volatility, they should be considered as part of the mix. We hope you found this overview of alternatives helpful, and thank you for listening to this episode of “Investment Management Foundations.” We hope you tune in for future episodes. Thank you.
This information is not intended as a recommendation. The opinions are subject to change at any time and no forecasts can be guaranteed. Investment decisions should always be made based on an investor's specific circumstances. Investing involves risk, including possible loss of principal.
