Financial innovation provides investors with a seemingly endless supply of new investment options. But the process of evaluating the merits of these investments remains the same even as the names change. Adopting a new component in one’s asset allocation represents a tradeoff that should carefully balance the expected benefit vs. the cost of its inclusion. The following framework highlights benefits investors may seek as well as potential drawbacks—a checklist that applies to any investment opportunity.

Properly evaluating whether something belongs in your portfolio begins with specifying the role it is expected to play. These roles come down to a) increasing your expected return or b) helping manage risk.

If the objective is to increase expected returns, what is the case for the asset in question accomplishing that? It is easy to link a positive expected return with equities, for example, as stock ownership gives you a claim on companies’ future cash flows. Similarly, bondholders expect to receive periodic interest payments and the return of their principal as stipulated in the bond’s covenant. But an asset that lacks a sound foundation for delivering a positive expected return should give investors pause, regardless of its past performance.

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