Stocks and bonds aren't the only things you can invest in, but financial experts say they're probably the best option for most people.
The huge declines in stock prices during the financial crisis understandably shook the confidence of many investors in traditional stock and bond portfolios. But the high-cost alternative investments that many have turned to since then have produced some disappointing results.
"The fear caused by the markets of 2008 and 2009 drove a lot of people to pay higher fees and incur bigger taxes, only to get underperformance," said Peter Mallouk, CEO of registered investment advisor Creative Planning. "Over the long run, if they had just stayed with a disciplined approach [in more traditional investments], they would be much better off."
The range of alternative assets now available to investors of all sizes has expanded exponentially since the financial crisis. Exchange-traded funds and the so-called liquid alternative funds offer exposure to everything from commodities and real estate to precious metals and a wide array of hedge fund trading strategies.
The selling point for most of them is that their returns are not closely correlated with the stock and bond markets. The case for investing in them, however, is weak.
The performance data on the seven categories of liquid alternative funds tracked by research firm Morningstar make that clear. All seven categories have dramatically underperformed the over the last six years, and most haven't done as well as bond indexes in most of those years, despite historically low interest rates. With the average cost of the alt funds several times more than the average actively managed equity fund, the poor performance is all the more striking.
"The liquid alternative funds are a disaster," Mallouk explained. "There is huge wealth being transferred to financial intermediaries in the alternatives space.
"Five years from now, people will be asking themselves why they paid so much to access those asset classes."
Like many financial advisors, Mallouk suggests that investors keep it simple if they want to diversify their portfolios further. Stocks and bonds in international and emerging markets are correlated with U.S. markets, but they provide some measure of diversification.
He also recommends that people add real estate investment trusts (REITs) and master limited partnerships (MLPs) to their portfolios. Both are relatively less correlated to the stock market and have the added benefit of offering higher yields than most fixed-income investments.
There are two reasons to invest in alternative assets: to enhance returns or to reduce risk and volatility. On the first front, most investors should probably give up the idea. Access to investments in the private equity, venture capital and hedge fund arenas are still generally restricted to accredited investors with large amounts of assets.
Even for wealthier and more sophisticated investors, those investments are arguably not worth the cost and effort needed to manage them. The California Public Employees Retirement System, for one, decided to abandon its $4 billion hedge fund investment program last year because of poor performance and the hassle of vetting funds.
"The threshold question that has to be answered is what are you trying to accomplish with the investment," said Grant Rawdin, CEO of Wescott Financial Advisory Group. "Unless a person really understands it and what it will accomplish, they are probably introducing more risk to their portfolio."
Alternative investments can and do reduce volatility of an equity portfolio. The returns of most of the alt fund categories have a low correlation to the stock market. If stock prices dive again, allocations to alternatives will soften the blow. Investors need to understand, however, that in good markets, alternatives will likely be a drag on investment results — as they have been since the financial crisis.
"For retail investors, the role of alternatives should be to reduce risk," said David Grecsek, director of investment strategy and research at advisory firm Aspiriant.
With the price of risky assets at these levels, he said his firm began using alternative strategies, such as market neutral investing, merger arbitrage and managed futures, since early 2014 to reduce overall risk.
"We have an expectation of lower returns and greater volatility going forward, so we're tilted toward risk reduction," he said.
To actually achieve a meaningful reduction of equity portfolio volatility, allocations to alternatives probably need to be in the range of 15 percent of assets, suggested Wescott's Rawdin. For clients particularly concerned about equity risk, he frequently recommends upping the allocation to bonds rather than venturing into alternatives.
The key to achieving a good outcome from investing in alternatives, however, is to have realistic expectations about the returns you'll get compared to the rest of your portfolio. Based on the volatile asset flows into and out of liquid alt funds over the last several years, that doesn't appear to be the case with a lot of investors.
"People have actually said to me that they want reduced volatility and more return," Rawdin said. "That's the Madoff portfolio."
He added, "You have to articulate what you want and whether it's doable, or else you'll get something that doesn't please you."
— By Andrew Osterland, special to CNBC.com