A convertible bond gives the holder the option—the right, but not the obligation—to exchange a corporate bond for a predetermined number of shares of common stock in the issuing company, creating the perception that an investor can enjoy the best of both worlds. If the stock does well, the holder can convert to equity. If it does poorly, the investor retains the "safety" of the bond and coupon payment. The market recognizes that this option has value: The interest rate on the convertible bond is less than it would be on a similar nonconvertible debt issue.

Here's why convertible bonds are not recommended:

If the reason for buying convertibles is to seek higher returns than nonconvertible bonds can provide, the more effective strategy is either increasing the equity allocation or increasing exposure to equity classes with higher expected returns, such as small-cap stocks, value stocks, and emerging market stocks. If the reason for buying convertibles is to reduce the overall risk of the equity portfolio, it is wiser to purchase nonconvertible investment-grade bonds.

A covered-call strategy involves investors writing (or selling) a call option on stocks already in their portfolios. In doing so, the option seller gives up all potential for appreciation above the option strike price. In exchange, the seller receives an upfront premium. If the call expires without being exercised, the portfolio return is based on the call premium and the value of the stock the call writer still owns. If the call is exercised, the call writer receives the call premium and surrenders the stock at the strike price.

While a covered-call strategy has some attraction, the negatives outweigh the benefits. For example, while a covered-call strategy provides the benefit of reducing the risk of "fat tails," or kurtosis (see Glossary), it eliminates the potential for the good fat tail (the highly positive return), while having no impact on the risk of the bad fat tail (the extremely negative return). This approach only reduces the size of the bad fat tail by the amount of the premiums collected. Risk-averse investors would much prefer the reverse.

Other negatives include tax inefficiency and trading costs. A more efficient strategy is reducing the equities allocation and increasing the allocation to high-quality fixed-income assets, while at the same time increasing exposure to value and small-cap stocks—riskier stocks with higher expected returns. Volatility and downside risk are reduced, while returns are achieved in a more tax-efficient manner. In addition, most of the potential upside is maintained.

Currency risk has no expected return. There is no evidence of persistent ability to generate profits from currency speculation. Investors should not use these instruments to make speculative bets on the direction of particular currencies against the dollar.

Investors seeking the diversification benefits of foreign-currency exposure can obtain those same benefits by investing in international equities that are unhedged for exchange-rate risk. On the fixed-income side, investors generally seek stability of the value of those assets, allowing them to take equity risk. Adding currency risk to fixed-income investments increases their volatility. Unhedged foreign-currency exposure for fixed-income investments is not generally recommended. On the other hand, some investors—such as those living part-time in a foreign country or planning to retire to a foreign country—may be sensitive to the prospect of a falling dollar. Such investors may benefit from hedging their dollar exposure by allocating part of their fixed-income portfolio toward achieving this hedge.

EE bonds are Treasury instruments and, like all Treasury instruments, are recommended for consideration in a portfolio. While they have a maturity of thirty years, the interest earned is based on the yield on the five-year Treasury note. Rates are announced each May and November, with the yield set at 90 percent of the average yields on five-year Treasury securities for the preceding six months. That becomes the annual rate applying to bonds for the next six-month earning period.

One reason to consider EE bonds is the special tax benefit available for education savings. For those qualifying, all or part of the interest earned on EE bonds can be excluded from taxable income when the bonds are redeemed to pay for post-secondary tuition and fees.

Investing in international bonds exposes you to a mixture of risks that are different for each country. A country's unique set of risks (political, economic, and cultural) make up what is collectively called its sovereign risk. This is the risk of a country defaulting on its debts denominated in foreign currencies. U.S. Treasury bonds entail no risk of default for U.S. investors. Default risk, however, is a real threat in emerging markets. Countries have defaulted on foreign-denominated debt because of their inability to generate sufficient foreign currency to repay their obligations.

Emerging market debt is a risky asset class, characterized by extreme volatility. Emerging market debt is similar in nature to high-yield bonds and possesses some of the same characteristics risk-averse investors find unattractive about the high-yield asset class. Among the negative features:

Those investors seeking exposure to the diversification benefits of investing in emerging markets should seek that exposure via equity investments. Due to the risky nature of the asset class, an investment in emerging market bonds should be considered an allocation to the asset class of equities.

Like convertible bonds, EIAs supposedly provide "the best of both worlds": potential rewards of equity investing without the downside risks (because of the guaranteed minimum return). The typical EIA has the following characteristics:

However, these products have so many negatives no one should consider investing in them. The high fees, commissions, tax inefficiency, penalties for early withdrawal, and their design make them unsuitable investments. All complexity favors the issuer by reducing potential payouts.

The only real benefit of the EIA is the guarantee, which applies only if the EIA is held for at least ten years. During severe bear markets, when the guarantees are the most valuable, the ability of the insurers to honor the guarantees may be in question.

The main reason investors consider including exposure to gold is as a hedge against inflation. However, while gold has been a "store of value" over the very long term (the real return being close to zero), gold may not provide that benefit even then. For example, in January 1980, gold traded at $850 an ounce. Twenty-nine years later—a period during which inflation averaged 3.55 percent—gold was trading at roughly $900 an ounce, a return of less than 0.2 percent a year. During this particular period, an investment in gold would have lost about 3.4 percent per annum in real terms, even before investment costs. Gold is too volatile to serve as an inflation hedge.

On the positive side, gold does have very low correlation to stocks and bonds and has provided a hedge against some "event risks." This is also true of a diversified commodities fund. All things considered, there is no compelling reason to include gold in a well-diversified portfolio.

Hedge funds differ from mutual funds in several ways.

Hedge fund managers seek to outperform market indices such as the S & P 500 by exploiting what they perceive as market mispricings. The problems:

It is worth noting that hedge funds also use the term "absolute return funds." The implication is they will provide solid returns in both bull and bear markets. But from 2003 through 2008, the HRFX Index of hedge funds gained just 0.7 percent per annum, underperforming every single major equity asset class, domestic and international, underperforming all high-quality fixed-income investments as well.

High-yield bonds have lower credit ratings—below BBB from Standard and Poor's and below Baa from Moody's—and higher yields than more creditworthy securities. Those higher yields are compensation for an investor's willingness to take incremental risks. Investors should not make the mistake of confusing yield with return. Part of that higher yield includes an expectation of default. In addition, most higher-yield bonds have call provisions: Investors require incremental yield for accepting the risk that the bond will be called prior to maturity.

As has been discussed, fixed-income instruments play three primary roles in a portfolio: (1) serving as a liquid reserve in the event of emergencies; (2) generating a stable cash flow; and (3) providing portfolio stability, allowing investors to take equity risk. High-yield bonds are too risky and too highly correlated with equity risk to serve these purposes. There are other negative characteristics:

Those investors seeking higher returns can do so more efficiently by adding a bit more equity risk to their portfolio or by adding more size and/or value risk. Historically, that has produced more efficient results. Investors who do allocate to this asset class should adjust their asset allocation to reflect the hybrid nature of these instruments. The following percentage allocation to equities should be considered based on the average credit rating of a fund: 20 percent for BB, 30 percent for B and 50 percent for CCC.^[4] Investors failing to make that adjustment may find they have exceeded their risk tolerance.

LBOs involve a private equity firm purchasing a public company, after which they generally take it private. When making their acquisitions, the private equity fund will typically employ minimal amounts of its own equity and use large levels of debt, hence the term "leveraged buyout." When the company is resold, the high leverage creates an opportunity for incremental returns on the limited amount of equity.

Historically, after all fees and expenses, LBOs have not outperformed the S&P 500 Index despite taking far more risk. In addition to poor performance, LBO investments are highly illiquid. Thus, investors have not been compensated with incremental returns for taking the liquidity risks. Investors seeking higher returns have superior alternatives, including adding size and value exposure to their equity allocations, or even adding their own leverage. This latter course, however, is not recommended either.

Leveraged funds are intended to increase, multiply, or magnify the return of an investment through the use of borrowings (or derivatives such as futures contracts and options) that the fund uses to increase its total investment. Over the long term, these funds have provided poor risk-adjusted returns.

MLPs are typically engaged in transportation, storage, and retail energy distribution. As an asset class, MLPs exhibit low correlation to both bonds and equities. Historically, they have provided returns appropriate for the risks entailed. However, there is no good way to obtain low-cost, diversified access to the asset class. The available alternatives all carry total expenses that are too high.

MBSs are sometimes called "mortgage pass-through certificates." The reason is that the security passes through the mortgage principal and interest payments to investors at a specific coupon. It also passes through any prepayments (unscheduled payments of principal). An investor in an MBS owns an undivided interest in a pool of mortgages serving as the security's underlying asset. As an MBS holder, the investor receives a pro rata share of the cash flows from the pool of mortgages.

The MBS has a higher stated yield compared to other forms of fixed-income investments of comparable credit quality. The higher yields are compensation for greater risk, in the form of credit risk, interest rate risk, and, since maturity is uncertain, maturity risk. The one exception for credit risk is MBSs issued by Ginnie Mae (GNMA), which carry the full faith and credit of the U.S. Treasury.

MBSs have asymmetric price risk: The investor has sold a continuous call to the borrower because the borrower has the right to prepay at any time. The life of the MBS will be shorter than expected if interest rates fall, refinancings exceeding expectations. If rates rise, the expected life of the MBS will lengthen, borrowers extending expected stays in their current homes and leaving the lender earning below market rates. The price the owner of the MBS receives for accepting both risks is the incremental yield over a Treasury bond with the same maturity as the expected average maturity of the MBS on its issuance. That incremental yield is a risk premium. The only way the investor collects that risk premium is if rates stay in a relatively narrow band. Otherwise, he gets the worst of all worlds. When rates rise, he is holding an investment whose duration is lengthening at just the wrong time. When rates fall, he is holding an investment whose duration is shortening at just the wrong time. Looking at an MBS in isolation, this risk is even greater than it seems: The risks of MBS can show up at exactly the wrong time in relation to what is happening with your equity holdings.

If an investor finds the risks acceptable, it is recommended that investments be limited to GNMAs.

PMEs are stock investments in companies mining gold, silver, and platinum. PMEs are equities, exposed to the risks of equity investing. Though we would expect PMEs to provide returns similar to equities, in the long run they have provided returns below those of the overall equity market.

PMEs have had low correlations to both U.S. equities and international equities, been negatively correlated to intermediate-term bonds, and positively correlated with inflation.^[5] Like collateralized commodity futures, they have occasionally provided stability to portfolios during periods of financial distress. However, there are some additional negatives to consider.

The first is that PMEs are highly volatile, often experiencing severe drops. Investors considering including PMEs in their portfolios must be prepared for such periods. The second is that as a "safe harbor" investment, PMEs tends to experience long periods of very low returns during periods of economic and political stability. Investors must be highly disciplined and patient. On the other hand, PMEs do experience short periods of very high returns, typically in times of crisis. It is in these periods of crises that investors have the most need to generate high returns.

Another negative is that there are currently no investment vehicles allowing you to access the asset class of PME that are low cost and low turnover.

All things considered, there is no compelling reason to include PMEs in a well-diversified portfolio.

Preferred stocks are technically equity investments. However, their dividends are paid before any dividends are paid to owners of the common stock. While preferred shareholders receive preference over common-equity holders, in the case of a Chapter 11 bankruptcy all debt holders have to be paid before any payment can be made to the preferred shareholders.

Unlike common stock, which may benefit from the potential growth in the value of a company, the investment return on preferred stocks is usually a function of the stock price and the fixed dividend yield, although some variable preferreds are available. The difference between conventional bonds and preferred stocks is that conventional bonds have a fixed maturity date while preferred stocks may not. There are other negatives:

In summary, the risks incurred when investing in preferred stocks make them inappropriate investments for individual investors.

The term "private equity" is often used to describe various types of privately placed (as opposed to publicly traded) investments. Within the broad category of private equity, there are three major subcategories: venture capital, leveraged buyouts (LBOs), and mezzanine financing.

With its allusion to privately available opportunities, even the name of this alternative asset class is tantalizing. Individual investors may yearn to be players in an arena dominated by institutional investors such as the Yale Endowment. With all their expenses and incentive fees, private equity investments have generally failed to deliver on their promise. The high returns earned by private equity investors have not been commensurate with the incremental risks. In fact, private equity returns have been similar to or below the returns of similarly risky publicly available equities (risky small-value stocks). Only the riskiest private equity investments—early stage venture capital—have outperformed publicly available securities.

With private equity, investors forgo the benefits of liquidity, transparency, broad diversification, and access to daily pricing enjoyed by mutual fund investors. Finally, the distributions of returns looks like a lottery ticket: Relatively high average return reflects the small possibility of truly outstanding return and the much larger probability of more modest or negative return.

Private equity investing is an unattractive proposition for the average investor.

Stable-value investments are fixed-income investment vehicles offered through defined-contribution savings and profit-sharing plans, as well as 529 college savings plans. The assets in stable-value funds are generally bonds and insurance contracts. They are purchased directly from banks and insurance companies, sellers that guarantee to maintain the value of the principal and all accumulated interest. They deliver the desired safety and stability by attempting to preserve principal and accumulated earnings. The evidence demonstrates that stable-value funds have produced higher returns than short-term fixed-income instruments and have done so with similar risk.

While the returns data is attractive, problems of lack of transparency make these complex investments inappropriate for investors unable to perform the required due diligence, such as analyzing (1) the risk profile (credit rating, maturity, individual bond structure, and liquidity) of the individual securities held in the portfolio; and (2) the credit rating of the insurance providers. Few if any investors have the skills and resources to do what is required to make an informed judgment. However, they may be the best fixed-income choice for investors in retirement plans: a superior alternative to high-cost, actively managed funds.

For those able to perform the necessary due diligence, the following are offered as criteria for an acceptable investment:

Structured products are packages of synthetic investment instruments specifically designed to appeal to needs that investors perceive are not being met by available securities. As a result, they are often packaged as asset-allocation tools to reduce portfolio risk.

Structured products usually consist of an actual note plus a derivative or spinoff product. This second product derives its economic value by linking to the price of another asset, typically a bond, commodity, currency, or equity. A derivative often takes the form of an option (a put or a call). The note pays interest at a set rate and schedule, and the derivative pays off at maturity.

Structured products are often promoted to investors as "debt securities." Depending on the specific structured product, full protection of the invested principal may be offered. In other cases, there may be limited protection or no protection at all.

These investments come with fancy names like Accumulators, Reverse Convertibles, STRATS, Super Track Notes, and a variety of forms of Principal Protection Notes. Having reviewed dozens of these products over the years, we have yet to see one with features making it worthy of investment consideration. There have always been more efficient alternatives to achieve the same objective. These products are meant to be sold, not bought.

Before purchasing any security, an investor should consider the transaction from the perspective of the issuer. The issuers of structured notes are generally large, sophisticated financial institutions who are not in the business of playing Santa Claus to investors. They don't issue securities with higher borrowing costs than they would otherwise have to pay. Investors need to ask themselves: Why do these firms issue these securities? The answer is obvious: The issuers have structured the securities to generate large profits for themselves, not for investors.

If a security looks like it has a high yield or high return, then there is a high degree of risk involved. Even if you cannot see the risk, you can be sure it is there.

It is highly recommended that investors avoid the whole category of structured notes.

A variable annuity (VA) is similar to a mutual fund account wrapped inside an insurance contract. VAs are purchased by making either a single outlay or series of payments. VAs differ from fixed payout annuities because the latter guarantee that a specific sum of money will be paid each period, generally monthly, regardless of fluctuations in the value of the annuity issuer's underlying investments. The value of a VA—thus, the amount that can ultimately be withdrawn—will fluctuate over time. In addition, unlike with a fixed annuity, the typical VA offers many different investment options. Typically, these are mutual funds called subaccounts, which can be managed by firms other than the issuer.

There are three investment-related motivations for considering the purchase of a variable annuity. First, as an insurance contract, its structure allows investment earnings to grow on a tax-deferred basis. Second, there is a life-insurance component, varying from product to product. Third, the investment contract can be converted into a lifetime annuity at a future date.

A fourth, non-investment-related reason for considering the purchase of a VA is creditor protection. Many states—New York, Florida, and Texas among them—protect assets in VAs from creditors. As these laws are complex, consult an attorney before purchasing (or getting talked into) a VA for this specific purpose. Doctors worried about malpractice suits, for example, might want to consider VAs, but they should be sure to purchase the right kind of annuity.

While VAs have some positive attributes, the negatives far exceed the benefits.

Although annuities allow for tax-deferred growth of earnings, that benefit usually comes at a high price. The first problem: Annuities convert what would otherwise be long-term capital gains into ordinary income. Second, the investment choices inside the typical VA are actively managed, so they tend to have high expenses. The historical evidence indicates high fees for below-benchmark performance. In addition, each fund usually levies an account charge of $10 to $25 per year. Total charges can exceed 3 percent, compared to the 0.1–0.2 percent total cost for some passive equity investments such as index funds. If you are going to purchase a VA, make sure you investigate the costs associated with the VA and its investment choices. Other negatives: