Content provided by Kostya Etus, CLS Investment/Research Analyst
Most asset classes can be put into two broad categories which are stocks and bonds. The combination of these categories is perhaps the most widely recognized form of investment diversification, in the simplest sense, and has been for decades. The idea of diversification stems from correlation (parallel movement), the less correlated a pair of investments are, the more of a diversification benefit you will achieve by combining them.
For example, bonds are typically thought of as safer investments than stocks, and they have historically exhibited lower volatility. But that does not mean bonds cannot exhibit negative returns, as was seen last year, luckily the stock market had a great year and counteracted the bond performance. The opposite reaction is typically seen in most market downturns as stocks show significant underperformance while bonds hold their ground. BUT… there are situations when both bonds and stocks exhibit negative returns (positive correlation), so what is an investor to do?
What about Cash? Cash alternative investments are not a very exciting investment option, but they do have a purpose in an investment portfolio. With cash, you attain an additional level of diversification. The return potential on these investments is not great, but they offer less risk of principal loss and thereby greater stability. This is particularly important for clients nearing their retirement and/or looking to reduce risk exposure. These clients have spent years accumulating gains, and the need for preservation of capital is quite important. Cash can also be related to short-term bonds, and similarly used to help reduce duration (interest rate sensitivity) of your portfolio.