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The case for alternative investments

I recently wrote about the most diversified stock portfolio on the planet using only two funds. But there is a case to use some alternative investments as well. Here's some background and the two alternative investments I use in my own portfolio.

With two ultra-low cost mutual funds or ETFs such as the Vanguard Total Stock Market Index Fund and Vanguard Total International Stock Index Fund, you can own virtually every publicly held company on the planet and have reached maximum diversification. The argument to put more into the risky portion of the portfolio is based on finding asset classes that zig when your stocks zag, thus adding more stability to your portfolio. These assets are said to have low, or even better, negative correlations.

Certain assets, such as options, futures, and hedge funds can have negative correlations to the stock and bond markets. And since you want your portfolio to be prepared for both sun and rain, that's a good thing. Unfortunately, however, their expected returns are very low or negative. The trick is to find asset classes with low correlations that also have positive expected returns.

REITs and precious metals

The two risky asset classes I use for alternative investments are real estate investment trusts and precious metals stocks. Correlations are not negative as they only sometimes zig when stocks zag.

For REITs, I use the Vanguard REIT Index Fund (VNQ) which owns an index of US REITs. I like precious metals stocks better than the metals themselves and use the Van Eck Gold Miners ETF (GDX) and the Vanguard Precious Metals and Mining Fund (VGPMX). All have low costs.

I recommend using both sparingly, putting no more than 10 percent of your US stock portfolio in REITs and no more than 10 percent of your international stock portfolio in precious metals stocks. If one of my clients already has a large percentage of their net worth in real estate, I will often pass on REITs. I rarely use the precious metals and mining fund with clients as it is so volatile it can make the stock market look boring.

An argument against using these asset classes is that they are already owned by the US and international index funds, meaning we are overweighting much as one could overweight financials or energy. While true, most real estate and the precious metals themselves are not owned in the public markets. Thus, by overweighting them, investors attain a better reflection of global wealth.

So alternative asset classes can help your portfolio if you stick to low cost investments that have positive expected returns. The key concept is that you must stick to it rather than move in and out, as doing so will nearly always results in buying high and selling low.

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