Modern Portfolio Theory & How Alternative Investments Can Help Diversify Your Portfolio

Modern Portfolio Theory (MPT) is a framework that helps investors maximize their return on investment while minimizing risk. MPT is based on the idea that by diversifying investments across different asset classes, investors can reduce the risk of losing money. The theory assumes that investors are rational and seek to maximize their return on investment.

MPT emphasizes the importance of diversification, which means investing in a mix of assets such as stocks, bonds, and cash. The theory suggests that by investing in a diverse set of assets, investors can achieve the highest possible return on their investment for a given level of risk. Diversification is one of the central tenets behind crafting a robust portfolio.

How you diversify can make a major difference in growth in good markets and resilience in volatile ones. The truth is that diversification in the stock market alone only provides so much protection or upside—and that’s if you’ve built the right kind of diversification in the first place.

Nearly every investor has some percentage of their portfolio wrapped up in stocks. After all, stocks are the primary value generator in one’s assortment of investments. However, having too much direct exposure to the stock market means exposing yourself to greater losses. But by making sure other, more historically stable investments have a place in your portfolio, you can help offset unrealized gains.

Having too much direct exposure to the stock market, however, means exposing yourself to greater losses

There are many ways to diversify your portfolio. Moving allocations from stocks to mutual funds and ETFs can mitigate your exposure to company-specific downturns but may leave you vulnerable to sector-wide losses. Bonds may underperform when interest rates are low, leaving you with little opportunity for meaningful gains.

This doesn’t give investors many viable diversification options that also have the potential to deliver meaningful value. Merely leaving one’s assets in a low-interest bond isn’t an appetizing option for anyone who wants to still avail themselves of the upside in a tough market. To seize on real investment opportunities, one has to look toward diversifying through alternative investments instead.

Alternative investing has become a popular portfolio staple for many. As of 2019, 23 percent of investors surveyed were said to include alternatives in their portfolios. Only 7 percent of investors had alternatives in their portfolio two decades prior. New alternative investing platforms make pursuing opportunities beyond the stock market easier. Better yet, there are several diversification opportunities within the world of alternative investments. Each offers something different, making it crucial to know everything about diversifying into alternative investments before you begin.

When you pick the best alternative investments to help you diversify your portfolio, you’re helping protect your assets while venturing into new markets. Here’s what you need to know about common diversification tactics, missteps, and opportunities within the world of alternatives.

Why Diversification is Essential in Today’s Market

Portfolio diversification is a must in any economy. In a bull market, diversification avails you to gains across several sectors, which can create significant value. During periods of market volatility, a balanced portfolio can help you weather the storm more easily. And depending on your investing goals, a diversified portfolio can even help create steady returns over a certain period of time.

If you’re like most investors, most of your portfolio likely consists of stocks. Stock holdings tend to be considered the riskiest asset in one’s broader portfolio. When markets perform well, having direct stock ownership means you reap the rewards. When markets are in flux or downswing, you’re left to roll with the punches of a stock that’s lost value. Unlike investment funds, which often reallocate their underlying investments to mitigate these kinds of losses.

That’s why it’s crucial to balance your exposure to the market through other means, such as investment funds, bonds, and alternative investments. One recent study concluded that a balanced portfolio of US stock, foreign stock, bonds, and short-term investments could provide an annual average return of almost 8 percent, based on historical stock performance. This means that a well-balanced portfolio doesn’t just help you avoid losses and risk; rather, it can also drive value that you may not have gotten otherwise.

With market volatility rising, diversification has become more crucial than ever. The market swings more dramatically than it has in years past. The COVID-19 pandemic’s economic toll on global markets has led to several swings of 1,000 points or more, which can wreak havoc on one’s portfolio every month. For example, the travel and hospitality sector experienced a nosedive during the first half of 2020. If your portfolio was too heavily invested in this area, odds are you’d be in for significant losses in the short- to medium-term. On the other hand, if you incorporated remote computing or video conferencing company stock as part of a broader portfolio, you would be able to benefit from gains in this area—offsetting losses you might have sustained elsewhere, like in airline stocks.

However, spreading your money across an assortment of stocks, bonds, and funds won’t cut it. Certain methods and mathematical factors make the difference between true diversification and well-intentioned—but incorrect—methods of spreading assets. Many investors end up “over diversifying,” which is when a portfolio stops adding more risk protection and increases the chance of lowered returns on your investing dollar. Plus, if you end up diversifying into market sectors, industries, and businesses you’re not familiar with, you’ll have a much harder time reading trends and making sure you’re putting your hard-earned money into the wrong asset.

Common Diversification Pitfalls

Your average investor knows that diversification is important and has likely considered ways to diversify. What few realize, however, is that not all attempts to diversify work. Some may even do more harm than good.

Stock Diversification

Stock diversification is more of a challenge than it might appear. After all, stocks are more volatile than other investment types, sliming the margin for error. Stock diversification is often mistaken for buying a ton of different stocks. This is far from the case, however. One landmark study found that larger investments in a handful of historically well-performing stocks generated a better return than a portfolio composed of a wider variety of stocks.

There are right and wrong ways to diversify your stock holdings as well. Expert advice suggests that most investors hold no more than 30 stocks in their portfolio, lest they be spread too thin and dilute returns. Adding stocks into your portfolio just for diversification means investing dollars into something other than your top-tier holdings. In this sense, diversification only serves to add bulk to your portfolio, rather than value or safety.

Other asset classes, like investment funds or bonds, may not be as flashy as stocks but add slow and stable growth. This can serve as a bulwark against stock-related losses and can also create long-term growth for your portfolio. This takes some pressure off your stock holdings to perform consistently, lest your portfolio loses significant value over time.

Fund Diversification

As with stocks, there is a vast assortment of different investment funds available. And, much like with stocks, some investors end up holding on to too many overlapping funds. This may result in you owning the same underlying properties in two different funds. This could happen by accident—if an investor doesn’t look at underlying assets for overlap—or through a misguided attempt to diversify holdings in a certain market segment or sector.

Overlapping funds can rob you of returns in the long run. If you participate in two mutual funds that invest in the same stock, you’ll end up paying a manager’s fee twice for the same return. This unnecessarily erodes your gains, meaning leaving value on the table (or, more accurately, a fund manager’s pocket).

Bond Diversification

Bonds are also included in common diversification strategies. Bonds give investors a guaranteed interest rate in exchange for their investment over a predetermined period of time. Depending on the bond (and the issuer), this investment can be among the safest available. Bonds don’t come with the same day-to-day fluctuations as stocks and can serve as a stable place to park one’s stock earnings during a down market.

However, bonds are imperfect and should play an ancillary role in your diversification strategy. For starters, bond rates are at significant lows right now. This means investors aren’t likely to make a meaningful return on their investment. Even in high-interest periods, bonds still have potential downsides, such as delivering less return than the market average. Bonds are one of the least volatile options, but it’s far from the only ones.

How Alternative Investments Can Help Diversify Your Portfolio

You can only diversify so much through the stock market, funds, and bonds. This kind of diversification may set you up to take advantage of market trends and mitigate some of your risk of lost value, but not nearly enough. If your assets are tied up almost exclusively in the market, you’re not maximizing your diversification options. That’s where alternative investments can help.

Broadly defined, alternative investments are any kind of investment that isn’t in stock, bond, investment fund, or cash. This is just the tip of the iceberg in the world of alternatives: other options include more exotic investments like artwork, rare coins, or fine wines. If you’re new to alternative investments, it’s better to stick with some of the more conventional options.

With alternatives, you can invest in many assets that appreciate in ways that aren’t directly pegged to market moves. This is known as “low correlation,” meaning that alternatives do not typically rise or fall in value when stocks do. Having several low-correlation assets within your portfolio helps preserve value in the event that stocks lose value, and many alternative assets enjoy a significantly low correlation value. In other words, alternatives can buck market trends.

Many alternative investment types and options are at the core of why they can play a meaningful role in diversifying your portfolio. Some alternatives are geared toward stability and slow, steady growth. Other alternatives permit investors to take on more risk in exchange for a heftier return than market averages. No matter your risk appetite, there’s an alternative investment out there to help you spread your assets out wisely.

Alternative Investment Opportunities for Diversification

The world of alternative investing is vast. Some alternatives, such as real estate or precious metals, are well-known options for your average investor. Others might be more niche, such as collecting fine art or investing in rare wines. There are plenty more that are somewhere in between these two extremes, which can offer investors a low-correlation investment opportunity that still plays a clear role in your overall portfolio.

Gold and Precious Metals

Gold and silver are perhaps the most well-known alternatives around. Both hold value well and have a low correlation with stocks, which means they offer a significant diversification opportunity when stock performance is sluggish or unpredictable.

Plus, precious metals as an asset class can offer investors a hedge against market downturns, as gold, in particular, has a lengthy history of retaining its value—or even increasing in value—during periods when markets are sluggish.

Gold has an inverse relationship with the ups and downs of the markets. When markets are down, gold prices tend to increase. For example, the S&P 500 lost half its value from December 2007 to February 2009, while gold rose by 14 percent during the same time span. This makes gold a great asset to include in your portfolio—be it during turbulent financial periods or periods of calm.

Be aware that getting into gold can come at a premium due to its stability: The return of gold as an investment reached almost 25 percent in 2020, and the annual average price of gold increased overall since 2015. The rate of return was 0.44 percent in 2022. That means investing in gold isn’t cheap, and you’ll have to put a fair amount of money into even a small position. Part of gold’s expense is its popularity, which has made it soar in recent years. Gold can help you diversify, but investing in it may require you to put a few too many eggs into one golden basket.

Agricultural Commodities

Commodities are another common option for alternative investors seeking to diversify from the stock market. Agricultural commodities are vital elements of the economy as well as society itself. Because commodities are so important, they make for a good alternative investment opportunity. Prices tend to stay consistent so long as supply and demand are balanced. When inflation strikes, agricultural prices tend to increase. This provides an excellent hedge against stock market losses.

Agriculture, food, and related industries contributed roughly $1.264 trillion to U.S. gross domestic product (GDP) in 2021, a 5.4-percent share. The sheer size of this economic sector makes it an alluring option for alternative investments. Remember that commodity prices can fluctuate depending on a host of factors, such as changing consumer demand and oversupply.

Real Estate

Real estate can offer investors a unique opportunity to diversify their holdings that may do more than just keep you from putting too much capital in one or several sectors. Real estate value, particularly in areas where the property is in high demand, can net you gains that exceed what you’d get on Wall Street.

There are a host of ways that investors can get into real estate. The most obvious is home ownership, particularly if you’re purchasing a home or plot of land for renting it. The same applies to development: building a home or commercial property. You’ll be able to pull money out of the market and build a passive income stream.

Investors can also participate in a real estate investment trust, allowing participants to own fractions of a property managed through a trust. REITs make it easy to invest in real estate without taking on any of the challenges of being a landlord or developer.

Bear in mind, however, that real estate can be a fickle investment, depending on where and when you invest. Real estate markets can be fickle, and investment properties may be more expensive to repair or maintain than expected. If you’re interested in real estate that doesn’t come with those challenges, enjoys steady land appreciation, and makes it easy to get started, then farmland investing may be a superior option for you.

Startup Investing in Emerging Industries

Startups are the lifeblood of the economy. They're the risk-takers, the innovators, and the creators. Without them, we wouldn't have things like Uber and Airbnb, or even more basic things like Google.

Startups are also a great way to invest in emerging industries like space—and it's not just because Elon Musk is working on something awesome up there. There are a lot of reasons why investing in a space startup is a good idea:

1. Startups are innovative: Space startups are at the forefront of innovation in their field, pushing boundaries that others can't even dream of reaching. This means that when you invest in one of these companies, you're not only investing in their success as a company but also contributing to our knowledge as a whole.

2. Their ideas have staying power: Space is a huge industry that touches every aspect of our lives—from entertainment to travel to medicine—so if you invest in a space startup today, you'll be able to watch it grow over time as they continue to expand into new markets and new fields (like artificial intelligence).

3. They're fun: It's exciting watching startups grow from tiny businesses into big corporations!

The Bottom Line on Using Alternatives for Diversification

For many investors, crafting a well-balanced portfolio goes beyond holding stocks and bonds. Alternative investments can offer more exposure to holdings that aren’t as dependent on overarching stock market trends. This can help reduce the risk of assets losing value when the market is sluggish. Better still, it can also provide you of new growth opportunities.

Spaced Ventures can be a great fit for investors looking for diversification through alternatives. Spaced Ventures makes it easier than ever before to get into the world of space startup investing. With as little as $100, you can start diversifying your portfolio with our array of offers for accredited and non-accredited investors.