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[Beware The House Of Cards] By Sven Carlin on September 19, 2016 [playing-card-842037_1920] - Stocks and bonds don’t provide diversification, while gold only does sometimes. - Alternative assets are better, but not all of them are equal. - Hedge funds perform well in bear markets but heavily underperform in bull markets. Introduction The increased market volatility after the quiet summer demonstrates how risky markets can be. The market falling by 2.5% in a few days on practically no news except for an increased probability of a small increase in in interest rates and no additional stimulus in Europe is a sign of the market’s fragility. A recession in the U.S. or Europe or a streak of negative news from China would quickly tip the house of cards. If you’ve enjoyed amazing returns in the last 7 years, the increased risks might urge you to look for protection and capital preservation at this point. This can be reached by looking at uncorrelated assets, which aren’t the usual suspects. Once Uncorrelated Assets Unfortunately, many think they are well diversified but owning stocks in various sectors or even international ones doesn’t mean you’re diversified. In an environment of low interest rates where stock prices increase not because of better fundamentals but instead because more funds buying in a reversal of the flow of funds is detrimental to all stocks, especially emerging markets. Markets, like emerging ones, that are less liquid and less familiar are usually the worst performers in bear markets. Bonds were once considered a good diversification asset as bond prices usually moved opposite to stocks. But with declining yields and monetary easing, the bond market has become artificial and lost its uncorrelated characteristics. [figure-1-correlation-bonds-stocks] Figure 1: U.S. stocks to bond correlation. Source: [Reserve Bank of Australia]. The high correlation was recently confirmed. As bond yields went up, and thus bond prices down, stock prices also went down. [figure-2-5-year-yield-and-sp-500] Figure 2: S&P 500 and 5-year treasury yield from Sep 8 to Sep 14. Source: [Yahoo Finance]. If you are diversified with various stock funds and bonds, you might see a big chunk of your portfolio disappear if higher interest rates or a bear market come. After bonds, the usual suspect for diversification is gold. It might look uncorrelated, but it gives you no certainty. In 2008, gold prices fell alongside stock prices and then rebounded only to decline in the last few years and not show correlation. [figure-3-gold-and-stocks] Figure 3: Gold and stocks. Source: [Market Realist]. The problem is that there isn’t a rule that can tell us when it’s a good time to invest in gold and therefore it has to be looked at as a speculative asset. All of the above will put you on the road toward alternative assets. Nobel laureate Harry Markowitz states that alternative investments lower your risk for the same return rate. [figure-4-markowitz-efficient-frontier] Figure 4: Efficient portfolio frontier. Source: [The Street]. [Misunderstood Option Strategy Earns Novice Trader $41 Million In Only 3 Years] Find out how you can use it to immediately generate substantial income when the market opens on Monday ... even if you're starting with limited funds. It's safe, reliable, and can be duplicated over and over again to generate income you can use right now if you want. Or you can let it snowball into even more. [Click Here To Learn This Strategy] [Easy-to-use Signal System Picks Stocks With Uncanny Accuracy] Here are several stocks our system said to buy: WNC shot up 288% after system said BUY VCI shot up 233% after system said BUY ETM shot up 953% after system said BUY Plus ... get over $398 worth of valuable books, videos, and reports just for trying this system risk-free for the next 30 days! [Click Here To Try It Risk-Free For The Next 30 Days!] Alternative Assets As diversification among stocks, bonds and gold won’t help much in case of a bear market, the only option left is alternative assets. Alternative assets come in many shapes and forms and include venture capital, private equity, hedge funds, art, rare coins, etc. The problem is that many hedge funds, venture capital and private equity funds are only for accredited investors, and thus don’t allow the average Joe to properly diversify. One option to diversify your portfolio is to buy put options. Put options will give you the right to sell an asset at a specified price by a predetermined date. The issue with put options is that if the asset doesn’t fall, you lose the complete value of the option as it expires, but on the other hand that is exactly their purpose, to provide you with an option. Thanks to the wide availability of ETFs, you can buy put options on almost any index and for a longer period of time. If you have a defensive stock portfolio, you can further protect it by buying put options on growth or small cap ETFs as growth stocks and small caps are expected to fall more in a bear market than large cap value stocks. There are also possibilities to invest in hedge funds. If you aren’t allowed to invest directly, you can follow what famous hedge fund managers do by looking at their 13F filings or buy an ETF that mimics hedge fund performance like the [Alpha Clone Alternative Alpha ETF] ([ALFA]). But if you look at the [holdings] of such a fund, you will again see a high level of correlation with the general market which suggests that hedge funds—and mimicking funds—have to be chosen carefully, though in general, hedge funds perform better in bear markets despite their heavy underperformance in bull markets. [figure-5-hedge-funds-sp-500] Figure 5: Performance of 1,800 hedge funds vs. the S&P 500. Source: [Barclay Hedge] and [Yahoo Finance]. The other benefit of mimicking a hedge fund portfolio is that you avoid the usual 2/20 fee structure. 2% yearly on assets under management and a 20% performance fee. Conclusion Diversification is a tricky subject as it can cost you if you change something in your portfolio and nothing changes in the markets, but in the long term, it should provide you with similar returns and less volatility. And, what you can always do is to switch between assets in relation to their inherent risks and yields. As the S&P 500 is approaching a high risk territory, it might be a good idea to switch a part of your portfolio into alternative assets. As soon as opportunity knocks in the form of a bear market, you can put the preserved liquidity back into stocks. 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