Investment critics have disparaged asset allocation and modern portfolio theory for several years, arguing that it simply does not work. However, the problem is not in asset allocation—it is in correlation, or the way two assets move in conjunction with one another.
Consider the S&P 500 index, the major domestic large-cap stock index in the United States, and the EAFE Index, the international large-cap stock index. Twenty years ago, their correlation was 0.4, which meant that the two indexes did not move together or apart from one another. (For reference, zero means very weak correlation, while 1 is highly correlated.) As a matter of fact, they really did not have any impact on each other's performance. Today, because of globalization and other factors, their correlation is 0.9, which means that these indexes virtually move in lockstep. This is an issue if you are trying to use investments in these indexes to offset each other's risk.
The real problem today is in finding asset classes that have varying levels of correlation, so your portfolio investments will not all go up or down at the same time.
Here are 11 asset classes that you should include in your portfolio, which will help you achieve an asset allocation with very different levels of correlation:
1. Large-, mid-, and small-cap stocks: Growth and value domestic stocks that have large, midsize, and small corporate capitalizations. These are standard in most portfolios.
2. Government bonds: Short-, intermediate-, and long-term debt instruments offered through U.S. federal, state, and local governments.
3. Corporate bonds: Short-, intermediate-, and long-term debt instruments offered by U.S. companies. These usually carry more risk than their government counterpart.
4. High-yield bonds: Short-, intermediate-, and long-term debt instruments offered by lower credit quality companies (typically lower than a BBB rating). These fixed-income investments are considered somewhat-to-very risky and usually carry a higher payout.
5. Currencies: Investments in currencies from countries throughout the world. Often, a good currency fund can invest both long and short, allowing it to capitalize on currencies that are increasing and decreasing in value.
6. Commodities: Investments in generic raw materials such as corn, sugar, wheat, oil, gold, cattle, etc. These investments can be very volatile as they are subject to many risks, including droughts, storms, and even wars. Many commodities can also be very predictable.
7. International real estate: Real estate investments outside of the United States. These investments can offer a high level of diversity due to their existence and valuations in so many countries.
8. International fixed income: Fixed-income investments (typically bonds) outside of the United States. Bonds outside of the United States can sometimes offer greater opportunities than those within the United States.
9. Emerging market debt: Bond investments in the developing markets. This asset class has performed very well over the last decade.
10. Managed futures: Long and short investments in futures contracts of things like oil, currencies, corn, etc. Often, these investments perform with mediocrity in good markets, but exceptionally well in bad ones.
11. Alternative investments: Non-traditional investments in things like business leases, non-public real estate, oil and gas, etc. They typically offer a very different or complete non-correlation to the U.S. stock market.
While some of these asset classes seem very familiar, many are not. Also, several of these were not available to the retail investor a short time ago. Their inclusion in your portfolio, however, offers a much higher level of diversification and non-correlation, which can significantly reduce risk and even raise return.
Kelly Campbell, Certified Financial Planner and Accredited Investment Fiduciary, is founder of Campbell Wealth Management, a Registered Investment Advisor in Fairfax, Va. Campbell is also the author of Fire Your Broker , a controversial look at the broker industry written as an empathetic response to the trials and tribulations that many investors have faced as the stock market cratered and their advisors abandoned their responsibilities to help them weather the storm.