The 60/40 portfolio has been the standard for decades. A simple ratio divides an investor’s portfolio into 60% stocks and 40% bonds. In theory, stock allocation provides higher expected returns (and volatility), while bond allocation provides lower expected returns (and volatility). One investment professional described it as follows:
Imagine that your portfolio is a sailboat…stocks would be the sails, harnessing the potential of the wind, and bonds would be the anchor, providing stability and safety when the water becomes choppy.
The 60%/40% (or “60/40”) asset split is the most common mix for what is termed a “balanced” portfolio. This allocation has become so ingrained in our investing culture that it has been referred to as the “Goldilocks portfolio”—not too risky, not overly safe, but just right.
The 60/40 portfolio has served investors well over many decades, providing a solid foundation for retirement income and long-term growth.
However, times have changed.
Today, institutional and retail investors are increasingly looking to alternative asset classes to provide more significant return potential with less volatility than traditional investments such as stocks and bonds. Alternative asset classes include real estate, private equity or venture capital, hedge funds, managed futures, art and antiques, commodities, and more.
81% of investors expect their allocation to alternatives to increase by 2025, with just 3% expecting their allocation to decrease. In other words, alternative assets are no longer an afterthought in portfolios; they are becoming mainstream.
What is fueling this shift? There are three main drivers:
- Return Potential
- Lower Volatility
Let’s explore each of these in detail.
One reason alternative assets have become so popular among investors is that they can generate higher returns.
Large endowments have taken advantage of this return potential for the last two decades. Yale’s esteemed late portfolio manager, David Swensen, grew the university endowment from $1 billion in 1985 to $31 billion in 2020. Over the last 30 years, their investments in non-traditional assets increased from less than 20% to greater than 70%, resulting in outsized returns and lower volatility.
Over the 20 years ending on June 30, 2020, private equity (PE) has produced average annual returns 3 - 4% above returns generated by the Russell 2000 and the S&P 500 over the same period. The chart below compares PreQIn (the Private Equity Quarterly Index), which measures private equity returns, and the S&P 500 returns from December 31, 2000, through December 31, 2014. PE has been a consistent winner over this period.
Further, real estate, as measured by the FTSE NAREIT Composite (an index that tracks North American Real Estate Investment Trusts), has consistently outperformed the S&P 500, even quickly overcoming the dramatic fall in real estate prices during the Great Recession. The situation today is even more extreme: Real estate prices are soaring worldwide, from 32% annual gains in Turkey to 13% in the US. Unfortunately, investors cannot purchase the FTSE NAREIT Composite, but several broad-based US REIT indices track various real estate market sectors.
As reported in the Knight Frank 2021 Wealth Report, several luxury investments have made outsized returns as well - though not all “objects of desire” are created equal. For example, in the last ten years, rare whiskey has provided nearly 500% returns, while cars have provided almost 200%.
Another famous alternative investment, Bitcoin, has been the best-performing asset of the last decade, beating the Nasdaq 100 by an order of magnitude.
This potential reward is part of what makes alternatives such compelling investment options today—their higher return potential provides investors with an opportunity to outperform conventional investments while reducing overall portfolio risk, which we’ll explore below.
Another reason alternatives have become so popular is diversification—alternatives allow investors to reduce concentration risk in their portfolios by spreading their bets across multiple asset classes rather than relying on one single investment strategy or sector performance.
By spreading your money across multiple strategies, you can help reduce downside risk if any individual investment strategy goes south while still benefiting from the upside potential of any successful strategies.
Diversification can also be used as a hedge against a market downturn by providing uncorrelated returns. For example, as JP Morgan shows in the chart below, the strategic selection of specific hedge fund strategies or tangible assets can provide low-correlation returns.
Diversification can also act as a hedge against inflation, with assets like gold typically increasing in value as the purchasing power of the dollar declines. This is particularly important today, with unprecedented government spending driving inflation.
While the official Consumer Price Index reports a 5.4% inflation rate, the actual figures are much higher. This is because the inflation calculation methodology has been edited and re-edited to make inflation appear lower. Calculating the Consumer Price Index based on the methodology employed before 1980 reveals an annual inflation rate closer to 15%.
While many benefits are associated with having a diverse portfolio, there are also some potential drawbacks.
Diversification may come at the cost of reduced liquidity, as alternatives, such as traditional real estate assets, cannot be readily liquidated during periods of low-interest rates. In addition, some alternatives require significant upfront costs, such as buying a business outright before profits are realized.
As we mentioned earlier, diversifying your portfolio reduces overall volatility by eliminating single points of failure – should one particular asset go down, another will pick up the slack, as visualized by the graphic below.
Alternatives also help protect against tail events – rare but potentially devastating occasions that could wipe out large portions of your portfolio - such as pandemics or geopolitical crises.
Both the financial crises of 2008 and 2020 were a wake-up call for many investors. They revealed that the stock market could turn on a dime, and many people lost money in the bear markets.
While it’s true that alternatives themselves can be volatile, they can also help you achieve your long-term goals without all the ups and downs of the stock market.
Alternative investments have been around for a long time but have only recently become mainstream. However, the financial crises of 2008 and 2020, and the subsequent government intervention, have created a new level of awareness for alternative investments.
In the past, alternative investments were typically only available for institutions or the ultra-wealthy. Now, with the help of platforms like Gridline, they are becoming more accessible to Main Street investors.
Institutional investors have been