Equity-Alternatives in Asset Allocation Discussions

A Unified Asset Allocation Equation

Asset Allocation can be more useful. The intent of asset allocation is to reflect the amount of risk to which you are exposed. But what about assets that are not stocks or bonds?

Equity-Alternatives are assets you buy for growth. They have unique risk and other investment characteristics vs. typical equities (stocks). They, along with bond and bond-alternatives, make up your asset allocation.

I like to use Equity-Alternatives and Bond-Alternatives when talking about alternative investments. This is because there is no existing classification system for alternative investments.

I suggest that alternatives be divided into equity- and bond- alternatives in a unified asset allocation. Then, we can include those asset allocations focused heavily on real estate or insurance products. A Unified Asset Allocation will allow us to express asset allocation as a simple equation: growth investments over safer investments.

Before we get ahead of ourselves, let’s understand your asset allocation equation before taking on equity-alternatives as a subclass of alternative investments.


Asset Allocation as an Equation

After deciding to invest, the next most important decision is asset allocation. However, before you can know what precisely to invest in, you must know how you will invest.

What sort of investor are you? Where am I comfortable taking risk to grow my money, and where should I keep my safer money safe?

There are hundreds of investments or asset classes. Are they risky, or do they have less risk?

Risky assets go on the top of the asset allocation equation. We expect them to grow because of a risk premium; we get paid to take the risk of owning the asset. Therefore, we expect growth of the investment.

If risky is on top, less risk goes on the bottom. Note that nothing is risk-free! It just depends on the type of risk you are willing to take!

Specifically, by “less risk,” we need to think about more than economic downturns. We expect a downturn in the economy every few years. You should have room for error, wiggle room, or a hedge against tail risks. This can be as simple as your emergency fund. Economic downturns affect our family and human capital differently, so we have other less risky pots of money. Many have bonds. Bond-alternatives and cash make up the rest of our “safer money.”

For ease, we will say equities on the top and bonds on the bottom.

Asset Allocation = Equities / Bonds = AA = E/B

This is the asset allocation equation: equities over bonds.


Equities over Bonds is the Asset Allocation Equation

The asset allocation equation is in the percentage of equities over bonds and sums to 100%.

Thus, 50% equities is E/B = 50/50 = 50%. Of course, the other 50% are bonds.

Some people split bonds into fixed-income and cash/cash alternatives. Still, that overcomplicates the situation because we look for safety at the bottom of the asset allocation equation. Or, since there is no safety, at least assets that are “safer.”

So, you can be 80/20 or 70/30 and be quite “aggressive,” or be 20/80 or 30/70 and be quite “risk-averse.”

The asset allocation equation is equities over bonds. Therefore, we can reach a unified asset allocation with real estate investors and insurance products by adding equity- and bond-alternatives to the asset allocation equation. Then, all alternatives (including insurance and real estate) can be broken down and expressed as an equation that sums to 100%.


Equity + Equity-Alternatives Over Bond + Bond-Alternatives

So, here is the equation for asset allocation:

(Equity + Equity-Alternatives) /  (Bond + Bond-Alternatives) =  E/B = Asset Allocation

The top is growth and assumes risk. Equities and equity-alternatives.

The bottom is the safer money, including fixed-income investments, bond-alternative, cash, and cash-alternatives.

How can we add equity-and bond-alternatives to the asset allocation equation?

Let’s get the Safer number out of the way first.


Bonds and More as the Safer Number

At the bottom of the asset allocation equation is safer money made up of fixed-income assets and bond-alternatives.

Cash is also included and not infrequently part of a barbell strategy where you have a lot of risk, a lot of cash, and not much in between. Cash-alternatives and cash are usually just subsumed into the “bond” or safer number.

But most frequently, you have one or two bond funds that make up the bulk of your safer money, and then you might have alternatives to bonds.

I have a blog on bond-alternatives that should be of interest to you. This is a big topic and includes many of the alternative assets. These specific alternative assets should be considered bond-alternatives.

Again, the idea is less risk, and return of the principle is more important than growth.

So, add up your cash, cash-alternatives, bond-alternatives (including appropriate insurance products and especially debt real estate), and your bonds and then express that as a percentage of your overall investible wealth. That’s the bottom number!

With the Safer number out of the way, let’s get to the main topic of this blog: the idea of equity-alternatives.


Equities have Equities and Equity-Alternatives

The top of the asset allocation equation is equities. Equities can be divided into stocks and equity-alternatives.

To be sure, I am not coining the word “equity-alternative,” but I am using it in a specific context in this case. It is not just “alternatives,” as those include asset classes that are bond-alternative and not equity-alternatives. The difference, again, is growth vs. safer money. If the intent is to replace risk, then it is an equity-alternative. If the objective is to replace “low risk,” it is a bond alternative.

So, what is an Equity-Alternative?

What is an Equity-Alternative?

An equity-alternative takes the place of stocks in your asset allocation. Stocks are the ownership of publicly traded businesses and are volatile. One must understand that the stock market might crash, but you don’t “lose” the money unless you sell and lock in the losses.

Some people cannot tolerate market volatility, and they should not invest in stocks.

But you need to invest for growth! So instead of the equity risk premium, some people might consider using the risk pooling premium or other insurance-based solutions for growth. Not ideal, but neither is selling at a market bottom!

Others think that stocks are risky and real estate is safe. That’s fine. Have some equity-alternatives but don’t forget about your safer money, too.

Moreover, bucketing (or mental account) is a behavioral technique that allows people to feel comfortable with volatility because you have buckets set aside for consumption for the next couple of years.

Again, that is fine. Not everyone should be 100% real estate or 100% stocks. Take risk depending on what seems risky to you, but remember to get your risk premium somehow.

Regardless of how you invest (real estate, stocks, insurance products, or something else), your asset allocation can be expressed via the asset allocation equation.

Real Estate ownership represents an equity-alternative, whereas real estate debt may be a bond-alternative. So, you can have half your money in real estate and still be 50/50 with your asset allocation, as some of the real estate falls undergrowth and some safer investments.


Growth vs. Safer Investments

In summary, asset allocation is growth investments over safer investments.

We have seen that real estate can be a stock-alternative or a bond-alternative. So you need to figure out where it goes in your asset allocation equation.

Insurance products, on the other hand, generally are bond-alternatives. So there are, of course, exceptions to this rule that we are not going to get into.

We can use any alternative investment and decide whether it is stock-like or bond-like and put a unified asset allocation in it. This describes, in general, what percentage of our investible assets are risk assets and which of them are safer assets.

Let’s talk a little more about Equity-Alternatives in Retirement.


Equity-Alternatives in Retirement

Asset allocation changes when you move from accumulation to transition and then again into your de-accumulation portfolio. This glidepath is your personal view of risk and safety over time. What should your asset allocation be five years before retirement, and then what should your asset allocation be during drawdown? 

It depends on how you approach the mitigatable retirement-specific risks.

I want to look specifically at equity-alternatives in retirement. We can learn a little about people’s comfort level with stock investing and their desire to use equity-alternatives.

ch to fund their retirement. Good for them, I say. I like a good bucket retirement plan, except it can be all reduced to a simple asset allocation. Add together the buckets, and you have risk on the top and a safer “bucket” on the bottom of your asset allocation equation.

In addition, there are many ways to build a bucking plan, and none of them are standard.


Also, surprisingly, 15% of folks are so-called “risk-wrap.”

This is a new term for me. It means you believe in the equity risk premium but want to commit to a strategy, especially one that mitigates risk in the future. Risk include:

They wrap their risk in insurance products. As for annuities, they would consider RILAs or even VAs.

As an aside, this reminds me of aggressively investing in a VA that had a benefit rider so that you can always turn on the income in the event of a poor sequence of returns, but you have the growth of the investments in case of clear sailing. So this is a way to deal with sequence risk with a VA.


Alternatives Investments Include Equity-Alternatives and Bond-Alternatives

Considering our overall asset allocation, we have our stocks and equity-alternatives for growth and our bonds and bond-alternatives for safer money.

Alternatives are much easier to access now, and many folks have some in their portfolio. An example might be a slush fund or a side investment fund where you invest in individual equities. While this is common and might be encouraged for 1-10% of your portfolio, depending on how much fun you have doing it, it is an equity alternative as it is not part of your inexpensive, broadly diversified ETF portfolio of equities.

Or your cryptoassets should be part of your asset allocation. They are an equity-alternative. Or Real Estate ownership. Another equity-alternative intended to grow your wealth.

As alternatives are easier to access and will play a more prominent role in portfolios in the future, we might as well start using the asset allocation equation to express our overall asset allocation in a simple, sensible equation.

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