Importance of Asset Allocation & Alternative Assets

In the investment world, 90% of the returns are determined by the asset allocation and remaining 10% returns are determined by the security selection. There are five major asset classes outside of cash: stocks, bonds, real estate, commodities and alternative assets. These asset classes can further be broken down into various subcategories such as domestic versus international (stocks and bonds both), growth versus value (stocks), large cap, mid cap and small cap (stocks), government, corporate and high yield (bonds), etc.

The key to successful investing is the asset allocation and one cannot emphasize enough on its importance to provide relatively steady returns. It is basically about creating an all-weather portfolio. It is designed in such a way that some of the parts of the portfolio out-perform while other parts under-perform. As a result, the overall portfolio provides steady and respectable returns for any given year with minimal amount of standard deviation. The key here is to minimize this standard deviation in returns of a portfolio.

It is a well accepted doctrine in the investment world that says one should have 10% to 20% of their assets in the alternative asset class including real estate and commodities categories aside from usual stocks, bonds and cash. One of the brightest investment minds, Mohamed El-Erian, even suggests putting one third of the portfolio in this asset class. In today's uncertain investment environment, one needs to take a hard look at the overall asset allocation and investments that can be a bastion or a source of visibility, stability and consistency.

The alternative asset class (also known as hedge funds or private funds) strives to provide absolute returns, i.e. positive returns, regardless of market's performance. Further, this alternative asset class is generally meant for high net-worth or ultra-wealthy investors only and it has gotten it's more than fair share of fame as well as blame. The alternative asset class is essentially a pay-for-performance industry, where fund managers can make good or even obscene amount of money (Richard Gere uses a phrase "obscene amount of money" in a film "Pretty Woman".)

Smart and talented money managers capable of delivering as well as me-too types of managers flock to this industry as they are highly motivated by its generous incentive structure. For example, a hedge fund manager, John Paulson (no not that Paulson), amid this world falling apart, made billions for him and his investors during 2007-2008 period.