Most investors destroy 100% or more of the performance from their alternative investments.
But it’s not all their fault. The types of risk that alternatives take are more numerous, more complex, and far less understood than the risks of more traditional portfolio allocations. As a result, Wall Street historically has had a difficult time placing alternative strategies into categories.
According to our latest research with the Financial Planning Association, even most financial advisors struggle to understand the role that alternatives should—or, more realistically, could—play in their portfolios. Their responses showed that some of the most misleading myths about alternative investments are still firmly entrenched in the investment world.
One of the most prominent myths: you can succeed with a small allocation to alternative investments.
Some 7 out of 10 planners surveyed invests 10% or less of their portfolios in alternatives. But Longboard’s research indicates that it takes a minimum allocation of 20% to true diversifiers to provide the kind of long-term benefit most asset managers seek.
Why? A small allocation to alternatives causes more problems than it solves.
If the markets move lower, the allocation is not big enough to meaningfully impact the results. Even when you narrow the field of alternative offerings to a true diversifier, like managed futures, adding only 5% to a 60/40 stocks and bonds portfolio only reduces the worst decline by a meager 91 bps: from -30.75% to -29.84%.
In rising markets, when there is little perceived need for diversification, a small allocation to alternatives is often seen as a drag on performance, leading to a lot of time-consuming explanations to clients.
With a larger allocation, alternatives can deliver a better investment experience—one with a smoother ride. That’s because they can augment portfolio diversification in 3 areas:
- Increase performance
- Lessen the effects of volatility
- Reduce worst decline
Decide for yourself what allocation makes the most sense by prioritizing your current needs accordingly, in rank order.
But, only invest if you’re prepared to use true diversifiers at a high enough allocation—over a minimum of a full market cycle. Otherwise, you might be creating more problems than you solve.