It took many years, but Wall Street finally came around. (The appeal of asset-based management fees over transactional commissions certainly helped.)  Nowadays it is the norm for financial advisors, aka investment advisors, financial planners, wealth managers, etc., to offer asset-allocation-based investment solutions. Who has not seen an asset allocation pie chart on their account statement or performance report?

Despite its benefits, modern portfolio theory is not foolproof. One of the biggest limitations is that its analysis is backward-looking. Wall Street firms “optimize” portfolios using historical data. Recall this famous disclaimer: “Past performance is not indicative of future results”? These approaches fail to consider current market conditions. For example, if one asset class, say stocks, is grossly expensive compared to another, say bonds, wouldn’t it make sense to reduce the allocation to stocks in favor of bonds in a balanced portfolio? Nevertheless, practitioners routinely place their clients into “cookie-cutter” asset-allocation models without regard to the present, much less, near-term outlook.

Another limitation is the lack of true diversification offered by just stocks and bonds. Historically, over the long run, stocks and bonds have exhibited positively correlated performance, meaning that they tend to move in the same direction. However, for the past two decades, investors have witnessed a stock-bond correlation that is consistently negative (stocks fall, bonds rise and vice-versa) until last year. 2022 served as a wake-up call as both stocks and bonds sold off hard.

Enter “Alts.”  Alternative investments can be loosely defined as anything that does not fit within the stock and bond categories. It can include alternative assets, such as real estate or precious metals, or alternative investment strategies, such as “hedge funds.”  Studies done by AQR Capital Management and others have shown that the inclusion of a third asset class can further improve a portfolio’s efficiency, as well as providing another source of return. Institutional investors have long known this and applied it to their portfolio management. You can too.