From age-old staples like gold to modern trendsetters like cryptocurrency, alternative options to stocks and bonds have long intrigued investors. However, not all investments are a wise choice for everyone to introduce into their portfolio. In this article, we’ll answer the question, “What are alternative investments?” We’ll also outline the case for and against these kinds of investments, so you can better understand what makes sense for you.
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What are alternative investments?
The term “alternative investments” is a catchall phrase used to describe any type of investment that is not a traditional stock or bond. Common alternatives include, but are not limited to:
- real estate (which in our view straddles the line between traditional and alternative)
- master limited partnerships (publicly traded business ventures)
- tax lien certificates
- privately held stock
- commodities like gold and silver
- cryptocurrencies like bitcoin
- mineral rights
There are two ways you can think of alternative investments:
The first includes investing in alternative asset classes, outlined above. When you invest in these kinds of assets, you’re buying them with the hope that they’ll increase in value over time.
Next, you have alternative trading strategies, which can involve traditional asset classes like stocks and bonds, but are not asset classes themselves. A popular example is long and short trading strategies. Taking a long trading position refers to buying a security and hoping it appreciates. In contrast, taking a short position means borrowing a security, selling it, and hoping the value depreciates so when you need to buy it back later to return what you borrowed, you make a profit on the difference.
Some investment managers engage in both long and short-term trading strategies at the same time, and often across a myriad of different asset classes, currencies, and options. While the assets they are trading might be traditional, the strategies themselves are considered alternatives because they’re non-traditional ways of trading, and they bring a different source of both risk and return to the portfolio.
Why invest in alternative investments?
It may be tempting to get caught up in the hype of stock market alternatives like cryptocurrency, but it’s important to proceed with caution. Let’s walk through the pros and cons of alternative investments.
Advantages Of Alternative Investments
Investing in places other than traditional stock and bond markets may offer one major perk: diversification.
By definition, an alternative investment is such because it doesn’t behave like stocks or bonds from a risk and return perspective. The economic factors that drive risk and return for stocks vs. farmland, for example, are different. So these two assets each provide a different experience for the investor. Circumstances that impact the value of stocks and bonds may not be the same as what impacts your alternative investments. If these investments continue to move out of sync with one another, you may end up with a portfolio with less volatility over time.
Disadvantages Of Alternative Investments
One of the biggest misconceptions about alternative investments is the idea that these assets or strategies can act as a magic bullet for investors, providing modest upside and little to no downside. Unfortunately, this is simply not the reality. Everything in investing is about tradeoffs, and alternatives are no different. All investments incur risk.
In addition, alternative investments are difficult to access for most investors, although this is rapidly changing. Twenty-five years ago, it was almost impossible for a retail investor to gain access to alternative asset classes or trading strategies. Even today, alternative investments can require higher account minimums and carry greater liquidity concerns than traditional investments, making their inclusion in a portfolio unsuitable for some investors.
Liquidity is often the most overlooked issue when managing alternatives because if you need cash and your assets are highly illiquid (meaning you can’t sell the investments quickly), your money could be tied up for years or you may be forced to sell at fire-sale prices.
Who should invest in alternative investments?
Alternative asset classes and alternative investment ideas are not a fit for everyone. Whether you should pursue them depends on your personal financial situation. Today, most investors’ needs can be met with a traditional investment portfolio of stocks, bonds, and cash. Real estate is one exception because it’s highly accessible. So much publicly traded real estate exists that many investors have exposure to it in their portfolios without knowing it.
Alternatives to investing in the stock market are best suited for people who have a relatively large portfolio when compared to their need for cash, rather than people who have a specific amount of wealth. Even if you’re a multi-millionaire, alternative investments likely wouldn’t be a fit for you if you spend large sums of money where liquidity would become an issue.
However, if you can live comfortably within your means, alternative investments might make sense for you. In this case, you’d probably be less concerned about absorbing the hit if the value of your investment fell significantly and liquidity wouldn’t be as much of an issue because you wouldn’t need access to the funds in the near-term. In addition (and often most importantly), alternatives are better suited for investors who have access to competent professionals who can advise on the merits and tax implications of the investments.
Pro Tip: Pursuing alternative investments is one thing, but a financial advisor proposing them to you is another thing entirely. If someone suggests alternative investment ideas to you (and especially if they present you with fancy marketing material), be skeptical about their motivation. Ask how they receive compensation. Many alternative investments carry commissions for advisors because they’re difficult to sell. You need to know that your advisor’s suggestion is in your best interest.
Regulations Governing Alternative Investments
We’ve now answered the questions “What are alternative investments?” and “Why invest in alternative investments?” To give you an even better idea of whether these investments might be a fit for you, let’s explore the regulations associated with them.
To purchase most alternative investments, you must be an accredited investor. This is defined by the Securities and Exchange Commission (SEC) as someone with either an investable net worth of over $1 million excluding their primary residence or an income that exceeds $200,000 (or $300,000 when combined with their spouse’s income).
These guardrails are in place to ensure investors have the assets or income to absorb the losses that can occur with alternative investments. On top of these criteria, the institution managing your investments may have other thresholds you must meet.
How To Get Started With Alternative Investments
If you don’t have a compelling reason to introduce alternatives into your portfolio and your needs are being met with your current investments, buying complex and illiquid assets with high management fees probably isn’t an appropriate (or necessary) move. So, consider what role these investments would play in your portfolio.
If you have a good reason to pursue alternatives, working with a financial advisor can be beneficial, especially if your comfort level with investing is low. A professional can help you understand what each investment in your portfolio is intended to accomplish and what inherent risks are associated, as well as what kind of returns you should expect. (Just keep in mind that no one can predict the future!)
When it comes to trading strategies like taking long or short positions, you need to understand the philosophy and process driving those strategies, as well as the people and costs involved.
Finally, with any investment, you need to know when and how you can access the assets and you need a way of tracking their performance. A common issue with alternative investments is if they’re not publicly traded, so you may not have visibility into how much they’re worth.
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