How Much of Your Retirement Portfolio Should be Allocated to Alternative Investments?
As investor interest in alternative investments rises, a particular question is becoming more and more common: “How much of a retirement portfolio should be allocated to alternative assets?”
At PENSCO, where we custody assets for our client’s self-directed IRAs, we field this question a lot—from clients, financial advisors and even the media. While we can’t offer investment advice, we know this is a fair question, and the typical response— “it depends on your risk tolerance, return objectives and time horizon”—isn’t the most satisfying answer. But these days, neither are the answers provided by traditional asset allocation approaches, which tend to suggest holding a mix of stocks, bonds and cash.
For instance, one well-known (but dated) asset allocation approach is to build a retirement portfolio based on owning your age in bonds (OYAIB), meaning that your bond allocation should equal your current age. So, if you’re 40 years old, then 40% of your portfolio would be held in bonds; if you’re 69 years old, 69% of your portfolio would be allocated to bonds.
Another traditional rule of thumb is to subtract your age from either 100 or 120 to determine the percentage of stocks in your portfolio. Following this calculation, if you retire at age 69, you should allocate between 31% and 51% of your assets to stocks.
But these traditional asset allocation suggestions overlook a vast and growing investment opportunity set—alternative investments.
Building a Retirement Portfolio: The Appeal of Alternative Investments
Alternative investments include everything from private equity, real estate and hedge funds, to promissory notes, private placements, timber and gold. These alternative assets can be owned in an IRA that you self-direct. The law only restricts IRA owners from investing in life insurance and collectibles.
Part of the appeal of alternatives is their ability to diversify a retirement portfolio.
But there’s another reason that alternative investments appeal to our clients—they allow retirement savers to invest in assets that they know and understand. For instance, clients who are avid real estate investors often feel more comfortable putting money into properties than mutual funds. Those who work in Silicon Valley are more comfortable investing in a start-up rather than bonds. Investors who love the outdoors may choose to invest in farmland or timber.
It’s only natural that if you have expertise in a particular alternative investment that you’d want to use it to your advantage in your retirement portfolio. That’s the benefit of a self-directed IRA—it allows you to invest in what you know in a tax-advantaged way.
From 10% to 77%, Allocating to Alternative Assets in an IRA
Now, let’s return to the initial question—how much of your retirement portfolio should be invested in alternatives?
A 2017 survey on investing trends, conducted by the Financial Planning Association and the Journal of Financial Planning, and sponsored by Longboard Asset Management, found that 73% of advisors who responded to the survey were allocating no more than 10% of client portfolios to alternative investments. (The study was not confined to retirement accounts).
But at PENSCO that alternative asset allocation figure is most likely far higher. Our clients often use self-directed IRAs for the specific purpose of investing retirement funds in alternative assets—an option not typically available in IRAs offered by traditional banks and brokerages. PENSCO clients, on average, have 77% of their self-directed IRA allocated to alternative assets, 13% in traded assets (such as mutual funds or stocks) and 10% in cash.
To put such a significant portion of a retirement portfolio in alternatives, our clients often work with a financial professional who can advise them on investment selection, due diligence and managing the asset. And keep in mind—retirement savers can have multiple IRAs, so our clients may hold IRAs at other institutions that follow more traditional asset allocation strategies.
In short, from 10% to 77%, there is no one-size-fits-all asset allocation recommendation for using alternative assets in a retirement portfolio. Factors like your spending rate, risk tolerance, time horizon, and whether or not you’ll receive a pension or Social Security play a role in determining how you build your retirement portfolio.
But if you prefer promissory notes to stocks or rental income to bonds, the good news is that self-directed IRAs give you the flexibility to invest the way you want—no matter what percentage you decide to allocate to alternatives.
This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.
PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. PENSCO is indirectly affiliated with a registered broker dealer and with a licensed small business investment company through Opus Bank (“Opus Affiliates”). Other than the Opus Affiliates, PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.