Most individuals follow a traditional investment approach. Their portfolios often have most of their assets—and the majority of their portfolio's risk—concentrated in equities in anticipation of generating higher longer-term performance. This approach is flawed since there is a significant risk of poor returns, which can threaten the ability to meet future obligations, such as retirement funding.
This asset allocation mistake was exposed over the past decade as investors realized woeful returns on their equity holdings. Major global events led to underperformance of traditional portfolios. Unfortunately, this global risk was not isolated to individuals and has resulted in many pension funds being seriously underfunded.
Does this mean that an investor should abandon equities? No, investors should hold well-diversified 'balanced' portfolios containing stocks, bonds and other uncorrelated assets.
The key phase being: uncorrelated assets. A portfolio should contain more than just U.S. stocks and bonds. It should have investments that do not move in direct lockstep with each other. And thanks to the growth of the ETF (exchange traded funds) industry, individuals now have a set of inexpensive investment vehicles to help balance risk.
While thousands of ETFs are available at reasonable fees, three are listed below that could help reduce overall portfolio risk if added to a traditional portfolio.
UBS ETRACS Risk-Off (ticker: OFF). An investment combining long and short positions in "risk off" instruments, including commodities, equities, currencies, sovereign bonds and precious metals.
iPath S&P 500 VIX (ticker: VXX). This investment's performance is linked to the volatility index for the S&P 500, Wall Street's fear index. It hedges against quick downturns in the market.
iShares MSCI Emerging Markets Minimum Volatility (ticker: EEMV). This investment holds low-beta, high-dividend paying stocks located in the emerging markets.
The potential benefits of these ETFs are that the individual investor can further diversify and fine-tune his portfolio risk by smoothing out performance, especially on the downside. In summary, an investor should seek multiple sources of uncorrelated returns to achieve more consistent performance.