A common way that investors attempt to protect their capital from the whims of equity markets is to allocate some of their money to alternative investments.  By definition, these alternatives are not stocks or bonds, so they have dissimilar price movements and are not correlated directly to the equity markets.

Typically as the prices of stocks move in one direction, alternatives (like real estate) don’t follow in the same direction .

Alternatives in your portfolio that are not correlated to equity markets are very effective at reducing portfolio volatility.

So what is the benefit to owning a portfolio with reduced volatility?  The press and finance professionals are always telling us how great diversification is – but what exactly does it do for you?  Why is monitoring volatility so important to how you manage your portfolio?

Simply put, less volatility means more money for you and your family in the long run.

Look at the example in the chart below. We start with a $100,000 investment represented by both the yellow and grey bars.  Both earn 1% interest per month, but the yellow nets that amount by going up 10% one month, and down 8% during the next month. This sequence repeats for every two-month period after that.  The surprise is how much the grey outperforms the yellow over time.  The difference is that the grey only goes up 4% and then down 2%, which is significantly less up and down price movements.

Volatility chartIn 20 years, the grey investment has accumulated more than double the amount of the yellow, and in 30 years it is six times more.  All because it has less volatility. 

So what is the secret to building a portfolio that has reduced volatility?  The Nobel Laureate, Harry Markowitz, taught us that if we mix two non-correlated price movement investments, we build a combined portfolio with less risk than both investments combined, but more return than at least one investment.

A simple rule for you as your own personal CIO (Chief Investment Officer) is to mix asset classes with non-correlated price movements.  In return, this will build an effectively diversified portfolio.

Obviously, just choosing any alternative doesn’t make your portfolio less volatile.  You must choose those that offer a solid return, such as real estate or other products not affected by equity market price movements.  Good, non-correlated alternatives should be able to produce income and not be affected by short term market movements.

Allocating a portion of your portfolio to well-chosen alternatives is a prudent long term investment strategy.  This will reduce the risk of volatility, and give you the opportunity to still earn competitive returns.

Many thanks to contributing author, Craig Martin.