Once upon a time in the investment world, the only decision was which stocks to pick. If those securities rose, great. But woe betide if they fell. Investors thus opted for conservative decisions.

We now live in a world where outcomes are judged on relative returns. The test is how securities perform against a rising or falling index.

The concept of relative returns largely owes its rise to Harry Markowitz. The US economist who died in June aged 95 was awarded the Nobel memorial prize for economic science in 1990 for forging portfolio theory. Markowitz made his mark with his paper of 1952 titled ‘Portfolio selection’ and his work of 1959 called ‘Portfolio selection: Efficient diversification of investments’.

As obituaries highlighted, Markowitz’s greatest contribution to investment theory was his analysis on the relationship between risk and reward.

Markowitz’s insight was that a portfolio’s risk was based less on the riskiness of each stock or asset found in a portfolio and depended more on how these assets related to one another. Markowitz’s work led to the insight that asset allocation was the major determinant of a portfolio’s risk, not security selection.

The concept that diversifying across asset classes lowers portfolio risk is now a principal of investing. Time has shown the major asset classes of bonds, cash and stocks perform differently and the right mix steadies returns.

The anchor of portfolio construction is the inverse correlation between bonds and stocks. Bonds usually decline when economies are humming enough to boost inflation, the enemy of fixed-income securities. Yet that thriving economy helps company profits and thus benefits stocks. The opposite usually happens in dour times.

These days, diversification across asset classes is the primary portfolio decision. The next step might be diversifying within asset classes. This can be done, for instance, by splitting asset allocations into local and global components. Want more diversification still? Then diversify within these local and global categories. Within local equities, that might be an allocation to small caps. Within global, it might be a portion in emerging markets. After all these asset-allocation decisions, then comes security selection.

So where do alternative investments fit into portfolio construction? Alternative assets here are defined as investments such as private equity, private credit and hedge funds that seek to deliver positive returns unrelated to the performance of any market benchmark.

Markowitz-initiated theories of portfolio construction would suggest the decision of whether to include alternative assets sits among the primary investment decision. That is to say, alternatives are a de-facto asset class that best figures in the ‘strategic’ asset allocation split along with bonds, cash and stocks.

Investing in alternatives is about entrusting a portion of a portfolio to an investment option that can deliver steady, positive returns year after year. Such an outcome is generally uncorrelated to the performance of the other asset classes.

A segment of a portfolio delivering such consistent outcomes would give a portfolio a better risk-return profile compared with the same portfolio without alternatives. The investment consequence of the Markowitz-inspired insight that diversification reduces risk is that it allows investors to reach towards higher-reward investment options. Such as alternatives.

To be sure, there is no set formula as to what percentage of a portfolio should be devoted to alternatives. That would depend on a person’s circumstances, investment goals, time horizon and risk appetite while considering the likely investment outlook. Asset-class correlations change with circumstances. No one can assume alternatives will perform as hoped.