Related topics: ETF, emerging markets, bonds, stocks, real estate
Robert Hort is 64, an age when many investors start to slow down a bit -- at least when it comes to where they put their money. Bonds begin to look more appealing than stocks, and cash looks like a safer bet than bonds.
So where is Hort, a business owner from suburban New York City, putting a chunk of his savings? Into some of the spookiest stuff on the market, such as junk bonds and commercial real estate.
"They help me sleep at night," says Hort.
For many investors, only a dose of sleeping pills would provide rest with a portfolio like that. But at a time when Hort should be thinking about safeguarding assets for retirement, he seems to be amping up his risk. Indeed, he's one of a growing number of investors thumbing their noses at the conventional wisdom, turning much of what they learned about investing upside down.
The old rules, of course, told investors to stick with a mix of stocks, high-quality bonds and cash, and to stay away from hard-to-fathom stuff like junk bonds, options and emerging markets. And for a long time, that strategy seemed to work. But after a decade of watching the stock market go nowhere -- and after the stomach-churning ups and downs of the past few years -- more investors are willing to try something new, even if it means stepping out of their comfort zones.
A growing number of market experts and financial advisers are telling them that some of the assets they were supposed to be afraid of can actually be good for them -- as long as they don't go too far. Commercial real estate, for instance, tracks the stock market only about 57% of the time, and some types of real-estate investing can offer yields of more than 8%, well above what most stocks and bonds provide.
Options such as puts and calls can act as insurance policies for stock holdings or generate income on the side, limiting losses in down or flat markets, says Hans Olsen, the chief investment officer for JPMorgan Chase's private-wealth-management business.
Some people are listening. Although billions of dollars have flowed out of domestic stocks and into bonds this year, investors have also poured $12.2 billion into emerging-market stock funds that invest not just in China and India but farther afield, such as in the Middle East and Africa.
An additional $2.1 billion has flowed into real-estate funds. At the same time, options trading volume is on the rise at some discount brokers. Though some investors are just chasing the latest trend, others have come to the conclusion that financial moves that seemed very scary not that long ago might provide balance to their portfolios and boost returns over the long run. "You can justify the risks," says Brian Kazanchy, a financial adviser in New Jersey.
Of course, no one is telling investors to abandon stocks and investment-grade bonds; advisers say they remain bedrocks of any sound portfolio. Hort, for example, keeps less than 30% of his portfolio in the risky stuff. And even as individual investors are catching on, the idea of building a basket of higher-risk investments isn't exactly a state secret. Many hedge funds have followed similar strategies for decades, and mutual funds are starting to employ them, too. Investment managers of Harvard and Yale endowments have used them for years, with long periods of success interrupted by big setbacks in the financial crisis.
Still, stepping up the risk even in part of a portfolio goes against the instincts of many investors, like telling your mother she was wrong about drinking milk and getting enough sleep. For investors who want to re-evaluate what they consider scary, here are four ways to start:
1. Rethink ratios. Is it all in your head? For many investors, the biggest hurdle to remaking a portfolio may be psychological. Losses have been so painful lately that we may have a distorted view of anything risky, says Hersh Shefrin, a behavioral-finance expert at Santa Clara University.
What's more, our brains are hard-wired to think of investments in isolation, attaching labels like "danger" to a class of assets. The upshot: We home in on the risks of things like junk bonds instead of "how the dots connect" in a portfolio, Shefrin says.
For example, emerging-market stocks and U.S. junk bonds rarely move in sync. When one zigs, the other may zag. Owning both can boost the odds of making money over time, says Michael Sheldon, the chief market strategist with RDM Financial in Westport, Conn.
More financial advisers are urging their clients to consider alternatives to U.S. stocks. According to investment-management company Russell Investments, 59% of advisers plan to boost their clients' exposure to emerging-market stocks, and 33% plan to increase exposure to real estate. Exactly how much should go into such nontraditional assets is a matter of debate, with some advisers urging clients to make them as much as 40% of their portfolios.
Thomas Meyer has steadily ramped up his clients' exposure to things like foreign debt, junk bonds and emerging markets. Such investments now account for 30% of his clients' portfolios, with the rest in stocks and bonds. Are they scared? Sure. But the Marlton, N.J., adviser says clients often come around after he pulls out charts and shows how their returns are likely to be higher over time -- with less risk along the way.
"Volatility is killing investors," he says, "and this stuff can help."
One way to think of these assets is as satellites orbiting a core portfolio of high-quality stocks and investment-grade bonds. Sheldon, the market strategist, points out that the satellites can't eliminate volatility or the potential for big losses, and it's best to ease into them over time.
Still, many investors who have tweaked their portfolios say they're comfortable with their new mix.
Lawrance Fineburg, a sales executive in Exeter, N.H., had a traditional portfolio of stocks and bonds before the crash but has since branched out to include things like junk bonds and emerging-market stocks. "My instinct was to avoid this stuff," he says. "But overall, I think my portfolio is safer."
2. Embrace risk. George Middleton knows his clients can turn ashen when he recommends junk bonds or debt issued by foreign governments. After all, these bonds look far dicier than old-fashioned Treasurys, and this year's debt debacles in Greece and Portugal have only made people more leery of anything that lacks an investment-grade credit rating. Investors' fear extends well beyond foreign bonds: According to a recent survey by insurance giant MetLife, 72% of advisers say their clients' approach to retirement savings has become more conservative as a result of the financial crisis.
Yet Middleton, an adviser in Vancouver, Wash., urges his clients to put their fears aside and take on a little more risk.
Junk bonds, which have yields of around 8%, have beaten the stock market this year. And to the surprise of many investors, they've also outperformed stocks over the past five and 10 years.
Analysts say some emerging-market debt looks even more attractive. Countries such as Brazil recently paid upward of 11% on their local-currency debt, even though government finances in many emerging markets are looking a lot healthier than those of European countries or the U.S.
"When you have significantly better balance sheets than the developed world, it's not that risky," says David Robbins, a foreign-bond manager with investment company TCW.
That doesn't make it easy to step up to the plate, especially after the meltdown of 2008. Behavioral economists say that's partly because losses are often experienced more intensely than gains. One way to ease the fears is to buy a basket of these bonds. The Artio Global High Income (JHYIX) fund, for instance, holds 233 debt securities, spread out over different credit qualities and industries. Manager Gregory Hopper says he likes the "boring middle class" of the junk universe and holds debt issued by solid companies, such as United Continental (UAL, news) and oil-and-gas company Plains Exploration & Production (PXP, news).
In emerging markets, Robbins has been buying things like Indonesian government debt and bonds issued by companies such as Pan American Energy of Argentina.
The indexes that track emerging-market debt were recently upgraded to investment grade, he notes. And even rising interest rates in these countries may not be so bad; such moves often make a country's currency more attractive to foreign investors, boosting its value. "There are a lot of tailwinds," says Robbins.
Of course, a sudden headwind can knock these investments off stride. Although default rates for junk bonds have been falling, they could increase if the economy weakens. And emerging markets could tumble if there's another flight to safety.
Yet the greater risk may be avoiding such investments, at least for a small chunk of one's portfolio. Middleton, for example, sees junk bonds as a long-term play, with "great potential over the next five years."
3. Buy what others are avoiding. For many investors, the idea of buying the things no one else wants sounds about as appealing as stepping into a haunted house alone. Most of us want to get out when the markets are going down and join the party when they're on the way up. At the same time, part of us knows that Warren Buffett is right when he urges us to be greedy when others are fearful.
Case in point: real estate. Many people, even those who don't own condos in Miami, now see real estate as a giant money pit. The nation's commercial market is littered with half-empty properties and unfinished buildings. And there's an estimated $1.4 trillion in commercial debt coming due in the next few years -- in many cases for buildings worth a fraction of their value before the crash. Still, while it can be risky, real estate doesn't always track the same path as stocks or bonds. That can help make real estate a winner when other asset classes are flat.
Though real estate overall still looks dismal, "there are some positive signals," says Stuart Gabriel, the director of the Ziman Center for Real Estate at UCLA. The number of properties entering the foreclosure process has slowed.
Even if real-estate prices stay flat for years, rental income can be a steady source of cash, buffering riskier investments in a portfolio, says Erik Miller, a financial planner in Portland, Ore. Some real-estate investment trusts, which hold commercial properties, yield more than 4%, almost double the recent yield of the average stock in the Standard & Poor's 500 Index ($INX).
Want to be even more contrarian? It requires a good bit of homework, but some investors are becoming commercial landlords, investing in so-called net-lease properties. The tenants agree to pay the taxes, insurance and maintenance -- and often sign leases for a decade or more.
It's possible to find properties with tenants such as Walgreen (WAG, news) or Capital One Financial (COF, news) where the risk of default is low, says Judson Kauffman, a broker with Marcus & Millichap. These properties tend to be more stable than other types of commercial real estate, he adds. And yields rose in the second quarter for the first time in a year; they recently averaged 8% for retail space and 8.4% for offices.
"It's like buying a corporate bond," says Randy Blankstein, the president of Boulder Group, an industry advisory company.
These properties aren't for everyone. With tenants locked in for years, landlords can't raise the rent in a hot market, and the properties tend to gain value much more slowly than more flexible types of real estate. Prices for a store leased to a high-quality company can start at $800,000, requiring a down payment of $200,000.
Still, Daniel Scotti, a retired physician in Vacaville, Calif., says his net-lease properties pay reliable income and are practically hassle-free. "I just cash the checks," he says.
