Everyone knows that diversification is a great strategy for lowering risk and raising returns if you can’t pick specific winning stocks. But at what point should you wave goodbye to your conventional stocks and bonds portfolio and start plowing your money into other things?
As with all investment-related answers, it depends on you. However, there are some key factors you should consider while talking to an alternative investment manager to double check you’re making the right decisions.
Tax Efficiency
The first question you’ll want to consider is tax efficiency. Are you getting good value for money by leaving stocks and bonds and going elsewhere?
These days, most asset classes are available inside protected tax wrappers. These can sometimes prevent the need to pay tax at all.
However, if you’re buying weird and wonderful assets, be careful. These might not be available through conventional tax schemes.
Inflation Protection
You will also need to think about whether diversifying beyond stocks and bonds will give you more inflation protection. Getting into areas that conventionally perform well, like oil, silver, and gold, could be a good option if you think prices will rise in the future. However, if you suspect that the macro-economy will just continue chugging along as it always has, then these investments might not be the best option.
Liquidity Requirements
You should also think carefully about your liquidity requirements when diversifying beyond stocks and bonds. Putting everything you have into a house might help you spread your money around, but it could also deprive you of the cash you need to thrive.
Liquidity is particularly important during market downturns. These offer the best opportunities to be greedy.
Concentration Risk
There’s also the issue of concentration risk. When your portfolio is just stocks and bonds, you are more susceptible to market corrections. If stocks go down, bonds are also likely to plummet, particularly in the corporate sector.
Sometimes, central banks will act in opposition to the direction of the market. For example, they will lower interest rates to spur demand. But the effect of this is usually to make new bond issuance less attractive. Alternatively, it can raise the value of existing bonds in the marketplace since the risk-free rate is lower than before.
Market Conditions
Diversification also makes sense when market conditions change.
Let’s say, for instance, that stocks’ P/E ratios are rising above their historical trend and that economic indicators suggest a recession is imminent. In this situation, it makes sense to liquidate stocks and put the cash into assets likely to do well during a downturn.
Similarly, if the price of bonds rises too high, it could suggest the market is overbought (perhaps because of the belief that the Fed will continue to cut interest rates). In this situation, it is also a good idea to get out of the market (as people did in 2022) to avoid a collapse. Then, when the price resets, you can get in at a lower amount.
So there you have it: some factors that determine what point you should diversify beyond stocks and bonds.
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