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By Paul Justice, CFA | 09-01-2010 11:04 AM

Beyond Cash, Stock, Bond Diversification

Exposure to many different sources of returns can make a well-behaved, well-balanced portfolio over the long term, says Vanguard's Sandip Bhagat.

Paul Justice: Thank you for joining me. I'm Paul Justice, director of ETF research, North America, for Morningstar.

Today, I'm reporting live from the ETF Invest Conference, and I'm joined by Sandip Bhagat, who is a principal of the Vanguard Group and the head of equities.

Sandip, thank you for joining me.

Sandip Bhagat: It's a pleasure to be here, Paul.

Justice: I would really like to get some ideas from you about building a core portfolio. The principal concept of stocks and bonds are enough for a portfolio. Do you support that viewpoint or do you think that there is more that people can bring into the mix to really give a better investor experience?

Bhagat: The stock, bond, cash framework is a useful starting point. Look, it's hard to get excited about cash right now with the yields close to zero. But we have seen what an important buffer it can be when equity volatility picks up and stock prices decline dramatically.

I would point out, however, that the inclusion of bonds and cash, while they reduce portfolio volatility, do come at the expense of returns. Equities provide a risk premium compensation for bearing risk, and you cut into that as you reduce portfolio volatility.

So as a thought, going forward, I might point out that positions in alternatives, alternative risk premia, where you do bear risk, get compensated through returns, but in a way that is different than equities, streams of returns that are somewhat less correlated with equities. That might be another way to diversify your portfolio beyond the traditional asset classes.

And the benefit of this approach, if done properly, is that you get the diversification perhaps without giving up as much of the return.

Justice: I think that most folks do strive to have those non-correlated assets that will generate some sort of positive risk-adjusted return. There are many choices that are available to people. How many can folks realistically put into the context of their portfolio, and just generally speaking, what types of funds might those be?

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