5 Alternative Investments to Protect Your Portfolio

In bear markets like this one, it's easy to bury your head in the sand and ignore the damage. Still, there's no time like the present for investors to school themselves on how to fix up a battered portfolio that can emerge stronger when markets finally get back to normal.

Alternative investments, a wide-ranging class of assets that include everything from commodities and annuities to real estate, can be part of that strategy, says Larry Swedroe, a director at Buckingham Asset management and an investment author. His latest book, The Only Guide to Alternative Investments You'll Ever Need, with Jared Kizer, is a guide to picking the best (and avoiding the worst) alternatives to basic stocks and bonds. Here are five of his favorites, with thoughts on how they might fit in your portfolio:

Real estate
That's right. The bogeyman of this downturn should still—someday—be a viable part of your portfolio. The housing bust makes it easy to shun the sector entirely, but real estate investment trusts, or REITs, historically offer unique risk-management benefits.

Over the past 20 years, REITs have helped juice returns and smooth out volatility. A sample portfolio from 1978 through 2007 shows that putting 10 percent of equity holdings in U.S. REITs improved returns by 0.3 percent and cut volatility by 0.9 percent, compared with investing in stocks alone. Real estate tends not to move in tandem with stocks, and it has almost no correlation with short-term bonds. (The obvious exception to the rule: 2008, when popular indexes like the Vanguard REIT ETF [VNQ] are off more than 40 percent year to date, just like equities.)

Real estate is a "low-correlating asset, not a no-correlating one, but that doesn't mean diversification isn't working," Swedroe says.

Inflation-protected securities
A slowing economy and the threat of deflation haunt the market today, but the return-killing specter of inflation will eventually re-emerge, if history is any guide. A small allocation of treasury inflation-protected securities, or TIPS, helps lower the risk of unexpected jumps in prices.

Like other bonds, TIPS offer a fixed rate of return, but returns are adjusted for inflation and can offset losses that can hit stocks when inflation starts to climb. There's a negative correlation between stocks and TIPS, Swedroe notes. In 2000, 2001, and 2002, for example, S&P 500 returns were off 9.1 percent, 11.9 percent, and 22.1 percent, respectively. During those years, the Lehman Brothers Treasury TIPS Index returned 13.2 percent, 7.9 percent, and 16.6 percent.

Plus, as a TIPS investor, you can also get a little extra yield by buying longer-term maturities, and you'll still sleep easier than if you'd bought traditional treasuries, since you'll know that inflation won't eat up your returns. "Even in the Great Depression, we did not go 10 years with cumulative deflation," Swedroe says. "So buy a 20-year TIP. The real risk is inflation."

Commodities
It may not be happening right now, but over time, commodities investments can offset swings in stocks and bonds. Commodities rise with inflation, which is negatively correlated with stocks and bonds. From 1973 through 2007, the Lehman Brothers Bond Index twice posted a negative return, once in 1994 and once in 1999, for an average 3 percent loss. In both years, the Goldman Sachs Commodity Index rose, for an average gain of 23.1 percent. During that same period, the S&P 500 had eight years of negative returns, and during six of those the commodity index was positive.

Plus, commodities tend to perform best when your portfolio needs them most. During times of strife or unexpected market shocks, commodity prices rise as supplies are threatened. Again, 2008 has been an exception, as commodities have fallen along with everything else because of slowing global demand.