Equity-Alternatives in Your Asset Allocation Equation

Equity-Alternatives in a Unified Asset Allocation


Equity-Alternatives are assets you buy for growth that have unique risk and other investment characteristics compared to stocks. They, along with bond and bond-alternatives, make up your asset allocation.

A google search for equity-alternatives goes right to alternative investments or employment stock compensation if you use parenthesis.

However, 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 even insurance products. A Unified Asset Allocation will allow us to express asset allocation as a simple equation: growth over safer investments.

Before we get ahead of ourselves, though, 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 decision is asset allocation. 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.

By less risk, I mean we need to think about more than economic downturns. We expect a downturn in the economy every few years. You should have some 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

By equities, we mean assets that place considerations of growth above risk. By bonds, we mean assets that place less risk (or safety) above growth. 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% is bonds.

Some people split bonds into fixed-income and cash/cash alternatives. Still, that overcomplicates the situation because we are looking 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, you have safer money made up of fixed-income assets and bond-alternatives.

Cash is also included and is not infrequently part of a barbell strategy where you have a lot of risk and 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.

I am not coining the word “equity-alternative,” to be sure, 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 under growth 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. There are, of course, exceptions to this rule that we are not going to get into.

We can use any alternative investment and decide if it is stock-like or bond-like and put in it a unified asset allocation. 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 own personal view of risk and safety over time. What should your asset allocation be 5 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.

For instance, using RISA data, about 35% of people are comfortable with stocks and bonds and use some version of a safe withdrawal rate. Their withdrawal plan is based on the equity risk premium.

A similar 35% are not comfortable with the equity risk premium and instead rely on the risk pooling premium and insurance guarantees. These are people who think about a good annuity when they retire.

The two other groups with each account for 15% of retirees include bucketing and what is being called “risk-wrap.” These are the exceptions that prove the rules, so let’s spend some time with each.


Bucketing is just mental accounting, or Time Segmentation, where you commit your “soon” money to safer investments. Building a wall of time into your portfolio is comforting to those who want “Safety-First yet Optionality.”

That is, they like front-loading their commitment via the “soon” bucket and leaving optionality for the other investments. These folks might use MYGAs as a bond-alternative, especially for after-tax money that will be annuitized in the future anyway.

Surprisingly, 15% of the population uses this behavioral crutch to fund their retirement. Good for them, I say. I actually like a good bucket retirement plan, except that fundamentally 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. Apparently, 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. This is a way to deal with sequence risk with a VA.


Why Own Equity-Alternatives?

Why own equity-alternatives?

Equity-alternatives grow your money by taking non-public equity risk. What alternatives to stocks have a risk premium in which you can participate? A risk premium means you make more money than the risk-free asset (say 10-year treasury) by taking investment risk.

However, there often is illiquidity with equity alternatives. Honestly, do not fear illiquidity. Do you actually need 100% liquidity all the time? The illiquidity premium can be a big part of the return for real estate, private equity, and other equity-alternatives and can not be ignored.

Moreover, there are access issues to alternatives and other investment-specific downsides.

Stock alternatives can be volatile and profitable. Therefore, there are multiple risks present. These are a few other considerations like regulation risk and low or negative correlation with other investments.


Ok, we have been through a lot already. Before finishing, let’s stop by and visit the classification and theory of asset allocation.


Theory of Asset Allocation

As I mentioned up top, asset allocation is the most critical decision you make after deciding to invest in the first place

As we discuss Growth/Safer, I want to mention why I am using “safer” rather than “defense asset” or anything similar.

While I like “defensive assets” because they often are employed to mitigate sequence of returns risk, there is so much more to “safer assets” than their defensive parts. Safer assets also are part of the withdrawal and rebalancing plan. And instead of just catastrophic defense, they are also part of the emergency fund and the 1-3 years of cash you have just cause you’re retired.

While in most straightforward terms, you want growth on the top, you want safety on the bottom, not defense. Safety to have a great retirement. Here is your checklist to make sure you have mitigated retirement-specific risks; or at least addressed them.


Classifying Alternative Investments

As I suggest that we classify alternative investments as equity- and bond-alternatives, what classifying systems of alternative investments are already out there?

From the most comprehensive tomb on Alternative Assets, CAIA Association has an extensive Introduction on the topic I encourage you to check out. It states: “There is no uniform definition of alternative investments or definitive list of alternative assets.”

If there is no definitive list of alternative assets, how are we supposed to classify them?

It seems the most straightforward classification system is tangible vs. intangible.


Tangible vs. Intangible Alternative Assets

Tangible alternative assets include real estate, natural resources, commodities, collectibles, and precious metals.

Intangible alternative assets include Hedge Funds, Private Equity, Venture Capital, Cryptoassets, Derivatives, and Structured Products.

We can do better. Tangible assets can be growth or safer assets. Intangible assets can be either as well. How does the fact you can touch something make a difference? The real difference is that it either takes the pace of a stock or a bond in your portfolio. I don’t think that alternative investments are tangible or not—they are equity- or bond-alternatives.


Alternatives Investments Include Equity-Alternatives and Bond-Alternatives

If we consider 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 clearly 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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