Investment Alternatives to Reduce Portfolio Risk

Alternative investments may reduce risks and taxes while increasing the total after tax return of your portfolio.

By Jason M. O’Dell, MS, CWM and Andrew Taylor, CFP
 

If you are like most investors, you have concerns about the global economy. We are eight years removed from the financial crisis of 2008 and have witnessed the S&P 500 index appreciate nearly 200 percent. Interest rates remain low by historical standards, and the threat of increasing rates presents the potential for bonds returns to disappoint investors interested in reducing equity exposure.

Central banks and governments throughout the globe have implemented an array of measures to stimulate growth in their respective local economies. The US financial markets have responded favorably to a multi-year trend of government spending. However, the days of artificial stimulus from the Federal Reserve appear to be coming to an end. In October 2014 the Fed announced the end of its long running bond purchase program, and in December 2015 the FOMC raised short-term interest rates for the first time in nearly a decade. A majority of economists anticipate Federal Reserve chair Janet Yellen will announce additional increases to the Federal Funds rate next year. Once the market’s safety net is removed, volatility will return and the US economy will have to stand on its own. For these reasons and many others, it is crucial that well-informed investors, including neurologists, adjust their investment behavior accordingly.

Investment Theory for Physicians

Most savvy doctor investors understand that portfolio diversification is a key consideration to reducing some of the risk of loss. In historically volatile markets, mitigation of loss is not a luxury; It is a necessity. Most educated investors who assumed they were “adequately diversified” still lost nearly half their portfolio value in 2008 and 2009. How did this happen? Most investors were diversified within the stock market with holdings in various sectors. What these investors suffered was “market risk.” The entire market came crashing down, as did all investors within the market.

Affluent individuals should approach investing with the goal of diversifying risk through non-correlated assets, allowing their funds to compound over time by achieving positive returns net of taxes and inflation with reduced volatility. This strategy does not suggest opportunity should be ignored; it simply states that risk must be properly managed and allocated. Generally speaking, this strategy is suitable for physicians of all ages, including neurologists, for different reasons. An established neurologist less than 10 years from retirement has likely accumulated significant assets and now needs to limit the range of possible outcomes for his or her established wealth. A young or middle-aged neurologist’s greatest asset is the ability to generate future earnings. A higher risk tolerance is appropriate for a doctor in this demographic, because the income earned will be significant enough throughout their career. With proper savings and risk management, the younger physician has no need to participate in speculative investments. Consistent after-tax returns and proper planning will be sufficient to allow a young physician to retire comfortably and maintain an appropriate standard of living.

What investors should understand is that diversification doesn’t need to be limited to securities like traditional stock and bond investments or bank deposits. Proper diversification must be across investment classes and not just within a class (such as securities or real estate)—especially in volatile markets that return periodically throughout an individual’s lifetime. A balance of domestic and foreign securities, real estate, small businesses, commodities, and other alternative investments would prove to be much less volatile than holding the majority of your investments in real estate and securities (which is what most doctors do).

Most doctors who contact us are either affluent and want to fine-tune their planning, or they are getting more involved in their financial planning and want to know the secrets of the more financially successful. Subsequently, many of our physician clients have taken a more active interest in surgery centers, medical office buildings and other healthcare related real estate. This strategy contradicts the idea of achieving portfolio diversification, by having a disproportionate amount of capital dependent upon the success of a single industry. One strategy of portfolio diversification for doctors is to avoid all healthcare related investments. The theory is that doctors already have a large portion of their income related to healthcare.

Alternative Investments

According to results of a recent world wealth report, the Q1 2016 allocation of the world’s high net worth individuals by investment class is expected to include a 15-percent allocation to alternative investments. A key benefit of alternative investments is the low correlation to broad equity markets. Non-traded alternative investments can provide a variety of roles in a physician’s portfolio.

Certain categories of alternatives have successfully served as a hedge in client portfolios in the past. In 2008, when multiple stock indices declined by nearly 50-percent from their peak values, a majority of managed futures strategies offered positive returns. Past performance does not provide assurance of future success. However, a hedging technique that helped minimize damage during the worst financial crisis most of us have experienced in our lifetime certainly warrants consideration. Master limited partnerships, business development companies, and certain hedge funds are additional examples of vehicles that have demonstrated a low correlation to traditional stocks and bonds.

For doctors who cannot build or participate in surgery centers or other profitable healthcare investments, a popular investment strategy is to take advantage of different investment programs that are not traded on a public exchange. Non-Traded Real Estate Investment Trusts (REITs), and Business Development Companies are a few examples. As with any investment, there are pros and cons for each type of offering.

Given recent market conditions, many physician investors have been attracted to non-traded programs because they offer a sense of stability. Most of these programs are available to investors at a flat price, for example $10 per share, during the offering period. An advantage to these programs is that their performance is not correlated with any particular market or index, making them an additional form of diversification. Holding non-correlated offerings may help reduce the “volatility rollercoaster” of a traditional portfolio. They should be an additional allocation in your portfolio, not a substitute for proper allocation.

Private investments generally offer a premium for the lack of liquidity. If proper due diligence is performed, an astute investor can identify these opportunities and will be compensated in the form of enhanced yield. Alternative investments offer access to strategies not available to the retail investor, investments that have traditionally been reserved for large endowments and institutions.

Word of Caution

It is important to note that one of the advantages of a non-traded offering is also a disadvantage. There is typically no market for shares of these programs. As an investor, you are expected to hang on to the security for the life of the investment—that can be as long as four to ten years. This makes your investment illiquid. In addition, these programs are not without risk. Your hedge fund could use a high degree of leverage, have a concentrated strategy, and actually add to the volatility of your larger portfolio. Like any other investment class, some offerings are more aggressive than others, and none make any guarantee about future performance. As with any investment, make sure you understand the investment and ancillary costs and fees associated with the investment, along with how it fits within your portfolio before committing to the strategy.

An Attractive Alternative

There has never been a better time to focus on investment risk management and tax reduction planning. If you are seeking ways to diversify traditional stock and bond portfolios and reduce portfolio volatility while possibly reducing unnecessary taxes, non-traded investments are an attractive alternative. n

1. Capgemini Wealth Report 2016

Jason M. O’Dell, MS, CWM is a financial consultant and an author of a number of national books for doctors, including For Doctors Only: A Guide to Working Less & Building More, as well as number of state books. He is a principal of the financial consulting firm OJM Group www.ojmgroup.com, where Andrew Taylor, CFP® is a wealth advisor. They can be reached at 877-656-4362 or odell@ojmgroup.com.

SPECIAL OFFERS:  To receive a free hardcopy of For Doctors Only: A Guide to Working Less & Building More, please call 877-656-4362. Visit www.ojmbookstore.com and enter promotional code PRNEUR18 for a free e-book download of For Doctors Only or the shorter For Doctors Only Highlights for your Kindle or iPad.

Disclosure:

OJM Group, LLC. (“OJM”) is an SEC registered investment adviser with its principal place of business in the State of Ohio. OJM and its representatives are in compliance with the current notice filing and registration requirements imposed upon registered investment advisers by those states in which OJM maintains clients. OJM may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. For information pertaining to the registration status of OJM, please contact OJM or refer to the Investment Adviser Public Disclosure web site www.adviserinfo.sec.gov.

For additional information about OJM, including fees and services, send for our disclosure brochure as set forth on Form ADV using the contact information herein. Please read the disclosure statement carefully before you invest or send money.

This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.

 

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About Practical Neurology

Launched in 2002, Practical Neurology is a publication uniquely dedicated to presenting current approaches to patient management, synthesis of emerging research and data, and analysis of industry news with a goal to facilitate practical application and improved clinical practice for all neurologists. Our straightforward articles give neurologists tools they can immediately put into practice.

 
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