Even street vendors hedge risk.
Walk down the street, in any large city and you’ll see vendors that sell everything from sunglasses to plastic rain ponchos. Most likely, there isn’t a customer on any given day that would buy both items at the same time. That’s the point. When it’s raining, it’s easier to sell rain ponchos but harder to sell sunglasses, and vice versa. By stocking both – and diversifying the product line – the vendor reduces the risk of losing money on any given day.
Of course in modern portfolio theory, asset allocation replaces rain ponchos and sunglasses with stocks and bonds (and cash), to diversify a portfolio and provide a level of reduced risk. For decades most investors have used some allocation of stocks, bonds and cash to manage the risk-adjusted returns in their portfolios, but over the past years, returns from many traditional asset classes have become highly correlated.
The key to risk-adjusted returns and diversification is not the number of securities – it’s their correlation – or, really, non-correlation – to each other, that’s paramount to a portfolio’s risk return efficiency.
The key to using alternatives is similar to diversifying with any asset class. Start with the end in mind, considering your portfolio objectives and risk tolerance. When considering alternative asset classes and strategies, understand that your choices are almost as varied as they are for stocks and fixed income.