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For decades, retirement savers focused on one simple question: how they should divide the bulk of their investments between stocks and bonds. More recently, a host of new asset classes that weren't readily available to individual investors have come on the scene. If you want the best portfolio you can put together, do you need the exposure these investments can give you?
Understanding the alternatives
Over the past two weeks, I've talked about the various components of a typical asset allocation model. Although the outlook for stocks isn't as positive as it has been historically, those who seek out the cream of the crop among individual stocks can still expect big rewards. Despite the superior returns on stocks, a healthy mix of fixed-income investments can help smooth out the impact of the stock market's ups and downs on your net worth. And even though cash doesn't grab a lot of attention, diversifying your cash holdings can help you protect against global trends like the dollar's potential devaluation over time.
That used to be all you had to worry about with asset allocation. But now there are all sorts of other types of assets you should consider. They include:
- Real estate investment trusts. This tax-favored structure gives companies like Weyerhaeuser (NYSE: WY ) and Annaly Capital (NYSE: NLY ) a way to avoid corporate-level tax. For investors, you can find REITs that focus on anything from residential mortgages and apartment buildings to mall properties and timberland.
- Commodities. Long seen as a trading place for strange items like pork bellies, the commodities arena is now front and center among those seeking diversification from stocks. The strong performance of gold has sparked ETFs like SPDR Gold Trust (NYSE: GLD ) , and you can find similar ETFs and funds covering a wide swath of the commodities markets.
- Private equity and hedge funds. To a large extent, these areas are still restricted to high-net-worth individuals. But increasingly, mutual funds are starting to emulate the same strategies hedge funds and private equity firms use. Now, you can find long-short and absolute return funds designed to perform differently from, and hopefully better than, stocks and bonds.
With all these new investments available, should you update your portfolio to include any of them? Or can you be just as happy with just the old three-legged stool of stocks, bonds, and cash?
Getting more sophisticated
At first, you might figure that you can get all the commodities or real estate exposure you need from traditional stocks. After all, if you think the price of metals will rise, then either Titanium Metals (NYSE: TIE ) or Freeport-McMoRan Copper & Gold (NYSE: FCX ) seem closely correlated to those markets. Similarly, to get real estate exposure, investing in Toll Brothers (NYSE: TOL ) or Hovnanian (NYSE: HOV ) seems like a no-brainer.
But when you look more closely, you'll see that companies that produce commodities don't always perform in line with the commodity itself. For instance, when you look at how the Philadelphia Gold/Silver Sector Index of precious metals stocks performed compared to gold and silver themselves, you'll see that the stock index trails both metals, and especially gold. That won't always be the case; sometimes, the stocks will outperform. The point, though, is that their returns over any given period can be far from identical.
Moreover, there's more to the question than just absolute return. In his look at this question, Fool retirement expert Robert Brokamp discovered that REITs outperformed U.S. and international stocks between 1972 and 2009, while commodities trailed stocks and REITs. But when you combined all of those asset types, you earned a return that was close to the top-returning asset class, but with a much smoother ride along the way. In other words, even though commodities lagged over the entire period, they often zigged when stocks and bonds zagged, providing some protection from market swoons.
Give it a try
Unfortunately, the best opportunity to buy REITs and commodities was last year during the financial crisis. Now, REITs have rebounded sharply, and many commodity prices have come off their lows.
Nevertheless, having some exposure to alternatives like REITs and commodities can make a lot of sense if you want a well-diversified portfolio. Their unique characteristics make both valuable additions to your retirement investments.
Learn more about putting together the perfect asset allocation from the experts at Rule Your Retirement. A 30-day free trial is just a click away.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.