Portfolio Theory and Alternative Investments

November 18, 2021

It’s the golden mantra of every investor: diversify, diversify, diversify. But for risk-averse investors, diversification can be a tricky art, especially if you’re not familiar with a lot of investments and leery of branching out of your comfort zone.

Yet diversification is also the most important thing you can do for your portfolio, whether you’re working with traditional investment assets or alternatives.

Here’s a look at portfolio theory, alternative investments, and how you can use portfolio theory to strengthen your alternative portfolio, even if you’re a risk-averse investor.

What is Portfolio Theory?

Portfolio theory, often called modern portfolio theory or MPT, is an investment strategy designed to help investors develop an asset portfolio aimed at maximizing expected returns for a given level of risk. The good news for risk-averse investors is that unlike many investment theories, this one assumes that you’re risk-averse, and that for a given level of expected return, investors will always prefer the less risky portfolio.

The core idea is relatively simple: maximizing returns without hitting an unacceptable level of risk.

Because of this, portfolio theory argues that no investment’s risk and return should be viewed in a vacuum. Instead, it should be viewed in context of the investor’s complete portfolio risk and return. Put another way, by thinking of potential investments as part of a whole, it’s easier for an investor to introduce new assets without raising the portfolio’s overall risk level.

Key Concepts in Modern Portfolio Theory

In portfolio theory, most investments are classified as either high risk/high return or low risk/low return. Harry Markowitz, the American economist who pioneered the theory and won a Nobel Prize for his work, argued that investors could achieve the best results for their money by choosing the optimal mix of assets based on their risk tolerance.

Sounds a lot like the advice your financial advisor gives you, doesn’t it?

Portfolio theory relies on statistical measures like variance and correlation to assess an asset’s performance as part of the complete portfolio. Diversification is central to the theory, since it aims to minimize idiosyncratic risk by holding assets that are not positively correlated (in other words, assets whose performance isn’t linked, like stocks and fine art).

Another key concept is acceptable risk, or risk tolerance. An investor’s goal with portfolio theory is to distribute risk among multiple assets while also keeping their portfolio at a level of acceptable risk across the board. In technical terms, the portfolio aims to be on the efficient frontier, maximizing the expected return for a given level of risk.

The Limits of Portfolio Theory

Like any investing theory, portfolio theory has its limitations.

For one thing, portfolio theory relies on the idea that the future will be like the past, since it relies on past historical data to calculate predicted future returns. And as every investment platform or ad on the planet Earth concedes, past performance is not an indicator of future success.

Another major criticism of portfolio theory is that it evaluates portfolios based on variance rather than downside risk. In other words, two portfolios with the same levels of variance and returns are considered equally desirable, but that doesn’t account for downside risk (an estimation of a security’s potential loss if market conditions precipitate a decline in the security’s price).

For example, those two portfolios might look the same, but a downside risk assessment might reveal that one of them has variance because of frequent small losses, while the other might have it due to rare but significant declines. Any smart investor would choose the portfolio with small frequent declines. This is a shortfall that postmodern portfolio theory aims to correct by calculating based on downside risk rather than variance.

Portfolio Theory, Alternative Investments: Where’s the Overlap?

When it comes to alternative investments, portfolio theory is a great choice to achieve a well-balanced portfolio.

Financial advisors generally agree that your portfolio should be 10% to 20% alternative investments in order to make an appreciable difference. In other words, your portfolio should be at least 80% to 90% everything else. Also, if you put all your eggs in one basket with alternative investments, you won’t see positive results, since it counteracts the effect of diversification.

Basically, portfolio theory is a great way to achieve the full advantages of alternative investments while also mitigating the risks attached to them. That’s incredibly important, since alternative investments tend to be riskier than conventional investments. By using portfolio theory, a risk-averse investor interested in alternative investments may be able to craft a portfolio that meets their risk tolerance and minimizes new risk introduced by new assets across the whole portfolio.

Plus, portfolio theory is a useful tool to analyze alternative investments as a holistic addition to the whole portfolio, rather than an asset viewed in isolation (a common trap for alternative investors, since many alternative investments are highly unique).

Applying Portfolio Theory to Alternative Investments

Applying portfolio theory to alternative investments is relatively straightforward, at least in principle. You just have to look at the variance and correlation among various investment options and consider their risk and return as an addition to the whole portfolio.

Remember, traditional portfolio theory doesn’t account for downside risk, so it’s a good idea to take a look at downside risk as well. This can be a little tricky with alternatives, so it helps to have an expert in your corner who can analyze downside risk for you.

The Smart Way to Approach Alternative Investments

If you’re thinking of trying your hand at portfolio theory, alternative investments, and portfolio theory applied to alternative investments, it pays to have an expert in your corner.

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