Most investors are familiar with stocks and bonds.  Beyond these traditional portfolio building blocks are a vast array of so-called alternative investments.  With this category, investors can gain access to currency, commodities, and active strategies that can add a new dimension to diversification.  Alternatives can also add to the total return of a portfolio.  By utilizing investments that are offered in exchange traded fund (ETF) or mutual fund format, gaining access to this asset class is a straightforward process. 

A good proxy for alternative investments is the HFRI Fund Weighted Composite Index, a 2000+ member index dating to 1990.  This index is composed of a number of alternative strategies and can serve as a benchmark to compare investments that fall in the alternatives category.

Putting the Pieces Together

Armed with a working knowledge of alternative investments, determining their efficacy in a traditional portfolio is a timely next step.  Consider an investor in a typical 60% equity (as measured by the S&P 500 index) and 40% fixed income (Barclays’ Aggregate Bond Index) portfolio.  If 4.5% of the portfolio is utilized each year for living expenses, with a 2.79% inflation assumption, what are the odds the portfolio would last thirty years?

The best way to determine this is by using a statistical sampling technique referred to as a Monte Carlo simulation.  By using an Excel spreadsheet or similar program, one randomly draws from a historical distribution of returns to determine a wide range of outcomes (there are a number of programs that can do this, so there is little need to understand the exact math involved).     

As one would expect, the answer is highly dependent on the return dynamics of the two investments.  If the portfolio would have been initiated at some random time, there is an 91.71% chance that the account would last thirty years.  But if the account started at the beginning of a bear market (which we define as a five year period of below average returns), the odds of success drops to 56.21%.

Now let's assume that the investor allocates 20% of the total account to the HFRI Weighted Fund Composite.  In all periods, the odds of success for the three asset-class portfolio jumps from 91.71% to 97.34%.  If the account started during a bear market, the odds are dramatically enhanced, with the chances for success jumping from 56.21% to 80.64% (see Table 1).

                                                            Table 1
                                        Odds a Portfolio Will Last 30 Years 

                                Traditional Portfolio          Traditional Portfolio
                                           Only                          with Alternatives

Portfolio begins
at Random Time               91.71%                                   97.34%

Portfolio begins
during Bear Market           56.21%                                   80.64%

Notes:

  • Traditional Portfolio:  60% S&P 500 Index, 40% Barclay's Aggregate Bond Index
  • Traditional Portfolio with Alternatives:  20% HFRI Composite, 48% S&P 500 Index, 32% Barclay's Aggregate Bond Index
  • Monte Carlo Simulation uses 242 monthly observations from January 1990 - February 2010
  • "Bear Market" is any five year period with equity returns less than average during 1990-2010
  • Investment fees are not included.