When I started this series, I began with some definitions to help the reader understand some of the jargon inherent to the discussion. One word I forgot to define is “correlation”. In financial terms, it refers to the extent to which the value of different asset classes (bonds, stocks, gold, etc.) move in relation to each other over time.

The value of shares of Ford and General Motors are highly correlated. They share the same industry and the shares themselves belong to an asset class we call stocks. Over time, a chart of their respective values follows essentially the same path. The same might be said of bonds issued by Ford and by General Motors; same asset class and same industry.

However, bonds and shares of stock are quite different asset classes and respond to markedly different market pressures. Typically, over time, if you put their respective values on the same chart, you would see little “correlation”. In other words, the ups and downs shown follow quite different paths.

The reason this is a valuable insight is that you want to own stuff that is uncorrelated. Because there are going to be inevitable ups and downs over time and to keep yourself asleep at night, you need to have confidence that not all of it is going down the tubes at any one time. But guess what happened in the fall of 2008? EVERYTHING went down the tubes. All of a sudden, there was a high correlation between the performance of stocks and bonds and all of it was down.

So people like me have been scratching our collective heads to figure out steps to take to mitigate the effects if such an event happens again. (Actually, I don’t think it will for about 70 years, by which time virtually all of us will be on another planet.) But whether it actually happens or not, there is a legitimate fear that it might, and we need a way for money to grow over time without that threat, if that’s possible.

I believe that incorporating alternative investments into your portfolio is a essential step. The issue becomes how, what will it cost, do I limit my upside if I limit my downside, can I trust the people with whom I’ve placed my money, etc. I think positive answers exists and its possible for the average investor to confidently participate in the solution.

A good alternative investment requires two things: low correlation to traditional asset classes and the ability to generate positive investment returns. And those positive returns typically happen most in bear markets, and we’re starting to see them perform well in bull markets, but by their nature, are not going to capture all the upside. The net effect over a full market cycle is more money on the table. Stay tuned…