NEW YORK – There's probably too much risk in your portfolio, and you don't even know it. So say the gurus at Rydex, an investment firm in Rockville, Md., with $6 billion in assets under management.
Traditionally, small investors have divided their investments among stocks, bonds and cash. According to John Mulvey, finance professor at Princeton University, and David Reilly, director of portfolio strategy at Rydex, these investments have come to behave like each other. For example, they often rise and fall in tandem. That correlation, they say, diminishes the risk-reducing benefits of diversification.
Mulvey and Reilly believe better results can be achieved by investing assets such as currencies and real estate whose performance isn't so tightly linked to the stock and bond markets. They also recommend investing in funds that trade futures and commodities, use debt and bet that stocks will fall in value.
In their research, Mulvey and Reilly compared the results of two hypothetical portfolios and used actual data from 1994 to 2004 to see what returns they would achieve. The first portfolio invested in Treasury bonds, domestic stocks, international stocks and cash. Its 10-year average annual return was 9.85%, and its volatility — measured as the standard deviation of annual returns — was 9.26%.
When Mulvey and Reilly shifted some assets in the portfolio to include funds that invest in real estate, commodities and options, the 10-year average annual return rose to 10.55% while the standard deviation fell to 7.97%.
In short, the more diversified portfolio had a slightly better return but much less risk.
For the small investor, an easy way to diversify is to include funds from prominent brokerages. Goldman Sachs, Fidelity and State Street Global Advisors, for example, offer funds that invest in alternative asset classes like real estate, commodities, currencies. There are also exchange-traded funds, which act like index mutual funds but trade like stocks, that represent those sectors as well.
Including these can help you keep hidden risk out of your portfolio while giving you more potential for gain.