Diversifying with Alts: Why It’s Extra Important for Your Portfolio

Imagine you’re baking a cake, but you only use one ingredient – flour. It wouldn’t be a very tasty or balanced cake, right? Investing is similar. Putting all your money into just one type of investment is like that flour-only cake – it’s risky and lacks the potential benefits of a well-rounded approach. That’s where diversification comes in, and it’s especially critical when you start exploring alternative investments.

Diversification, in simple terms, means spreading your investments across different types of assets. Think of it as not putting all your eggs in one basket. If one basket falls and breaks, you still have eggs in other baskets. In investing, if one type of investment performs poorly, others might do well, potentially cushioning your overall portfolio from significant losses.

Now, let’s talk about alternative investments, often called “alts” for short. These are investments that fall outside the traditional categories of stocks (shares in companies) and bonds (loans to governments or companies). Examples of alternative investments include things like real estate, private equity (investing in companies not listed on the stock market), hedge funds (investment partnerships using complex strategies), commodities (raw materials like oil or gold), and even collectibles like art or wine.

Why are alternative investments considered “alternative”? Often, they behave differently from stocks and bonds. For example, when the stock market goes down, real estate prices might not necessarily follow the same pattern. This different behavior is a key reason why including alternatives can boost diversification. They can act as a counterbalance to the ups and downs of traditional markets.

However, alternative investments often come with their own set of unique risks. Many are less liquid than stocks and bonds, meaning it might be harder to quickly sell them and get your cash back. Think about selling a share of stock versus selling a piece of real estate – the stock is usually much faster to sell. Also, some alternative investments are less regulated and can be more complex to understand than traditional investments. Private equity, for instance, involves investing in businesses that are not publicly traded, which can mean less transparency and potentially higher risk.

This is precisely why diversification becomes even more important when you include alternative investments in your portfolio. Because alternatives can be less predictable and potentially riskier than traditional investments, spreading your money across a variety of them, and also across traditional assets, becomes essential for managing risk.

Imagine you decide to invest a portion of your portfolio in private equity. If you put all your alternative investment money into just one private equity fund focused on a single industry, and that industry faces a downturn, your entire alternative investment portion could suffer significantly. However, if you diversified your alternative investments by spreading them across different types of alternatives – perhaps some real estate, some commodities, and a few different private equity funds focusing on different sectors – you’d be much better positioned to weather any storms in one particular area.

In essence, diversification with alternative investments isn’t just about spreading your money across different types of assets (like stocks, bonds, and alternatives). It’s also about diversifying within the alternative investment space itself. Just as you wouldn’t invest all your stock money in a single company’s stock, you shouldn’t invest all your alternative investment money in just one type of alternative or a single investment within that alternative category.

By diversifying your portfolio, including a thoughtful mix of alternative investments alongside traditional assets, you aim to create a more resilient and potentially higher-performing portfolio over the long term. It’s about building that well-rounded “cake” – using a variety of ingredients to create something stronger and more satisfying than just relying on one. Remember, diversification is a key tool in your investor toolkit, especially when navigating the world of alternative investments.