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| The Basics | Simple ways to diversify beyond stocks, bonds
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Here's a guide to adding commodities or real estate to a basic investment portfolio -- and a few tips to help you decide if now is the time to branch out.
By Mary Rowland
When the stock market hits the skids, as it has too often in recent years, investors always ask me: What can I buy that is not a stock? Stocks don't look so good. You're an investment columnist. Give me some alternatives.
I will give you some alternatives. But let me say straightaway that this is a flawed approach to investing. One of the reasons many investors do so poorly is because they react rather than act. They fail to develop a strategy. They buy stocks when the market is hitting new highs. And then when it sinks, they want to buy something else.
The time to buy stocks is when they are down. And the way to use alternative asset classes is to make them a part of your strategy, a part of your everyday portfolio. But before you do that, you have to think seriously about how they will perform. Stocks are the best-performing asset class over time. Their performance can be ragged, but they go up more than they go down.
The reason to invest in alternative asset classes is to give you diversification when stocks go down, to prevent your entire portfolio from sinking to its knees. So you want to find assets that have a negative correlation to stocks.
But what most new investors aren't prepared for is that if they are successful, if they find assets with a negative correlation, these assets will drop in a bull market. That means that your friends who are invested 100% in stocks will do better than you in a bull market.
What matters, though, is who wins in the end, and the evidence shows that diversification produces the best long-term results.
Alternative asset No. 1: real estate
Beginning investors can diversify a portfolio by adding top-performing sector funds and low-correlation sector funds to a core of index mutual funds. They also can invest in foreign stocks. Here, we'll talk about assets other than stocks and bonds, chiefly real estate and commodities.
Let's take real estate first. Real estate has a pretty decent record of running counter to stocks. In 2000, for instance, when the S&P 500 ($INX) was down 9.11% and the Nasdaq ($COMPX) was off nearly 40%, the National Association of Real Estate Investment Trust Index was up 26.37%.
Most Americans already have a real estate investment: their home. And I think you should start there. What kind of investment did you make in your home? Is it speculative? A fixer-upper with big appreciation potential? Or a standard suburban home? My husband and I bought a home a couple of years ago on a fairly large and well-placed piece of property. We bought it at a good time. We think it has appreciation potential and don't believe we need to add other real estate to our portfolio.
Consider rental real estate
But investing in property beyond your home can be an excellent way to add real estate. For instance, one of the members in our Start Investing Community, who calls herself "Jeanrichnot," bought a home, borrowed against it to buy a beachfront property and added a third property by refinancing the other two. She lives in the cheapest of the three and rents out the other two. So Jean is covered in the real estate category.
Those who prefer to buy real estate through securities typically look at real estate investment trusts, or REITs, which trade on the stock exchanges. REITs, which are similar to mutual funds but hold real estate rather than stocks or bonds, come in three flavors: - Equity REITs, which hold property.
- Mortgage REITs, which hold mortgages.
- A hybrid variety that combines the two.
The most important question about REITs is whether they reflect real estate as an asset class. Many financial planners believe that real estate belongs in client portfolios, but they don't believe that REITs represent real estate. Instead, they believe REITs act sometimes like stocks and sometimes like bonds.
Barry Vinocur, who writes the REITs column for Barron's, as well as a newsletter called the Realty Stock Review, has long held the view that the data on the returns of REITs is flawed. Data collection goes back to the early 1970s. But the market was revolutionized in the early 1990s, when there was a huge influx of commercial real estate. "The modern REIT era starts in 1993," he says. "You can hang your hat on the data from 1993 to 2000."
So Vinocur says he'll feel better about the REIT data after we've been through a few more market cycles. Still, he says that recent studies have looked at the correlation between REITs and technology and found that the two are negatively correlated and that REITs can be a good hedge for technology.
REITs also offer a dividend yield of around 7% or 8% with little worry that the dividend will be cut, Vinocur says. He recommends that investors with a three- to five-year time horizon put 7% or 8% of a portfolio in REITs. "They're very good income-oriented investments with appreciation potential," he said. The largest REIT, Simon Property Group (SPG, news, msgs) is a good place to start, he says.
Financial planners who use real estate often buy through real-estate mutual funds, but most of these funds carry hefty load charges or 12b-1 fees. Vanguard REIT Index Fund (VGSIX) is a good alternative with no load, no 12b-1 fee and a very low expense ratio of 0.33%.
Alternative asset No. 2: Commodities
Like real estate, commodities -- oil, lumber and other hard assets -- have a decent record of negative correlation with stocks. Inflation sends the price of these hard assets up and it hurts the stock market.
Trouble is, there are so few good ways to tap into that hedge. The Goldman Sachs Commodity Index charts the movement of these assets. That index was up 49.74% in 2000. The only fund I know that follows the Goldman index is the Oppenheimer Real Asset Fund (QRACX), and it has two strikes against it: It packs a front-end load fee, and it has just a three-year record.
The fund may be worth looking at for those investors who use a financial planner, allowing them to buy it without the load. But you're either paying a fee or a commission, so in effect, you're paying a load anyway.
I use energy as a commodities substitute in my own portfolio, where I own Fidelity Select Energy Services (FSESX) and Exxon Mobil (XOM, news, msgs). Other possibilities are natural resources funds that invest in chemicals, metals and building materials like T.Rowe Price New Era (PRNEX) and Fidelity Select Industrial Materials (FSDPX).
It goes without saying, I think, that buying these investments when they've been beaten down is better than buying at the top of the cycle. We argue all the time in the Start Investing community about whether or not this is market timing. I say, who cares? If I've identified investments I want to hold in my portfolio, I'd much rather buy them when they're cheap than when they're expensive.
At the time of publication, Mary Rowland owned or controlled the following funds and securities listed in this column: Fidelity Select Energy Services, Enron and Exxon Mobil.
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