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Have you ever come across the term ‘Alternative Investments’ and wondered what it means? Well, you’re in the right place to get some answers! Alternatives fall outside of the conventional investment vehicles, meaning they invest in asset classes other than traditional cash, stocks, and bonds.
By taking a less conservative approach, alternative investments allow traders to chase much higher returns than would otherwise be available in the traditional investing arena. However, as is the case with any asset class, as return rates increase so do the risks.
In this comprehensive guide, we’ve covered everything you need to know about alternative investments—how they work, what types of assets they cover, types of returns offered, underlying risks, and more.
Let’s start by exploring what an alternative investment is in more detail.
What are Alternative Investments?
Before delving into the specifics, it might be best to first assess what a traditional investment is. Typically, a traditional asset class will either come in the form of equity or income. Regarding equity, this will cover stocks. In other words, when you purchase a blue-chip stock, you effectively own a piece of the company—proportionate to the amount you invest.
With regards to income, a good example of an income-based investment is bonds. Generally bonds pay a fixed rate of interest every month, quarter or year, thus your investment will generate a regular income.
Other traditional investments can include the following:
- Exchange Traded Funds (typically stock market indices only)
- Mutual Funds
That being said, an alternative investment will fall outside of the above parameters. In order to understand the types of assets that this can cover, let’s take a look at some examples below.
Types of Alternative Investments
When discussing non-traditional asset classes, commodities are often at the top of the list. Important to note that commodity trading is a multi-trillion dollar industry that effectively operates on a 24/7 basis. Tradable commodities include precious metals such as gold, silver and platinum; energy (oil, natural gas); agricultural products (e.g. wheat, sugar, coffee), as well as livestock and meat.
Although popular, commodities are quite risky as their underlying value is dictated purely by market forces. They don’t produce income but often yield negative results, and don’t provide an investor with equity or ownership rights.
Another popular alternative is real estate investment which can come in two forms—direct and indirect. A direct way would be purchasing and owning a physical property (houses, land plots) with the idea of making capital gains on the sale of the home, passive income via rental income, or a combination of the two.
Investors can also put their money in real estate investment trusts (REITs) as an indirect way of investing in real estate. For those unaware, REITs are large-scale companies that purchase multiple real estate holdings—both in the private and commercial sectors. Much in the same way as publicly listed stocks, REITs allow investors to purchase shares in the company.
Venture Capital and Private Equity
Venture capital and private equity investments are similar insofar as they invest in private businesses. Private equity firms invest in or buy already established and even sometimes failing companies. The idea is to streamline operations in order to turn a profit.
On the other hand, venture capital firms inject capital in startups that are usually high risk but can yield high returns due to their growth potential. Think about backing the likes of Facebook, Uber, or NetFlix before they went public.
While venture capital firms are limited to technology startups (cleantech, biotech), private equity firms can buy companies from any industry.
Along with being highly risky, such investments are also inherently less liquid whereas startups lack business maturity and most private equity companies are not publicly traded. This means that offloading the investment in the open marketplace is very difficult, if at all possible. That is why investors play the long game because their rewards can be extremely fruitful.
While the derivatives industry is now a highly complex battleground—with the likes of mortgage-backed securities, debt swaps and contracts-for-difference, the most common form can be found in futures and options. These asset vehicles allow sophisticated investors to speculate on the future direction of an asset, or group of assets, in an unconventional manner.
For example, an options contract would allow investors to speculate that the price of Apple shares will exceed $300 by the end of 2020. The investor would simply be required to pay a small premium to have the option of purchasing Apple shares if the market value surpassed the strike price of $300. If they don’t, then the investor would simply lose the premium.
In what started as a programmer’s dream has since turned into a multi billion dollar industry. As such, the cryptocurrency trading market now allows investors to buy and sell digital currencies at an array of third-party exchanges. However, cryptocurrencies like Bitcoin are one of the most speculative, high-risk asset classes in the investment space. In fact, double-digit price increases/decreases within a 24 hour timeframe are not so uncommon.
In terms of their classification, cryptocurrencies are often regarded as a commodity like gold, insofar that they have finite value and don’t yield any equity or income. As such, cryptocurrencies are an excellent example of an alternative investment.
Art, Wine and Other Collectibles
Art, wine, classic cars, antiques and other collectibles are also considered alternative investments. Shrewd investors and uber-wealthy individuals know the real value of collectibles and over the years amass a sizeable collection. Investors speculate that the collectibles will appreciate in value over time allowing them to turn a profit. However, it is a very risky investment as its value relies on many different factors; supply and demand, changing market forces, physical state of the collectible, etc.
So now that we’ve given you some examples of what an alternative investment looks like, in the next section of our guide we are going to explore the benefits and risks.
What Are the Benefits of Alternative Investments?
Although the traditional investment arena goes through ups and downs, we generally have an idea as to how much a balanced portfolio can make. For example, stock market indices such as the S&P 500 has made an average annual return of 10% since it was launched in 1926.
The Dow Jones, on the other hand, has averaged annual returns of 5.42% since its inception way back in 1896. In the case of income-generating investments such as bonds, we know what our returns are going to be throughout the duration of the investment, as the yields are fixed.
However, when it comes to alternative investments, the returns can be significantly higher. For example, the Invesco S&P SmallCap Health Care ETF—an ETF that tracks small-to-medium sized companies in the medical industry, made a whopping 29.55% in 2018. One year prior, cryptocurrency Bitcoin made gains of 2,000% in just 12 months.
The key point is that while the risks are greater, alternative investments have a much higher return potential than traditional assets.
Alternative investments also give you the opportunity to diversify against your traditional portfolio. For example, if your portfolio mainly consists of blue-chip stocks and shares, you are potentially over-exposed to a downfall in the wider economy. This was especially true at the height of the financial crisis in 2008, where just a handful of stocks avoided a significant drop in value.
On the contrary, a number of alternative investments are not impacted when the traditional stock markets suffer. In fact, certain alternatives such as gold actually rally. In such a case, you have the chance to mitigate your long-term risks by allocating a small proportion of your portfolio into alternative asset classes.
It is also important to note that alternative investments give retail investors access to markets that would otherwise be difficult to reach. This is especially true in the foreign bond market. For example, if you wanted to purchase bonds that were issued by the government of Argentina, it would be very challenging to get a look-in as an everyday investor.
The main reason for this is that government bonds issued outside of your own country must be purchased in high-volume lots that can often exceed a million dollars. As this is out of reach for the vast majority of us, an alternative investment such as a bond ETF would allow us to access global bond markets.
What Are the Risks of Alternative Investments?
Higher risk of losses
If you’ve read some of our other material, then you’ll likely remember that we often refer to ‘Risk vs Reward’ model. In the case of alternative investments, while it is true that the upside potential is much higher than a traditional asset class, so are the risks. Whether it’s commodities like gold and silver, or REITs in the emerging markets, volatility levels can be staggering.
In more extreme cases, cryptocurrencies and penny shares can lose the vast majority of their market capitalization in a matter of days. Ultimately, while some alternative investments come with more risk than others, you need to ensure that you always have an exit strategy in the event that the market moves against you.
One of the best things about the traditional financial markets is high liquidity. For example, when it comes to selling your blue-chip stocks during market hours, your trade will likely be executed in a matter of seconds.
On the flip side, alternative investments are inherently less liquid. This poses a greater risk, making it difficult to offload your investment as fewer buyers are active in the market.
Unlike stocks and shares, alternative investments are often accustomed to far less regulatory scrutiny. This means that in some cases, key bodies such as the Financial Industry Regulatory Authority (FINRA) and SEC will not have regulatory oversight over the alternative investments you hold.
This could become problematic in the event that the issuer of the financial investment fails. It could also be a problem if the issuer takes on more risk than would otherwise be allowed in the traditional investment space.
Should I Incorporate Alternative Investments Into My Portfolio?
If you’ve read our guide up to this point, then you’ll know that alternative investments come with both advantages and disadvantages. On the one hand, they offer far greater upside potential, diversification, and access to otherwise difficult to reach markets. On the other hand, this comes with the risks of loose regulation, high volatility, and in most cases, low liquidity.
As such, although you might have a slightly higher appetite for risk in comparison to the average investor, it is still wise that you limit your exposure to alternative investments. A good starting point might be to aim for the 5%-10% range. While the vast bulk of your investment portfolio should contain a balance of large-cap stocks and bonds, the remainder could be reserved for some alternative investment products.
Ultimately, you should be opting for markets with sufficient levels of liquidity. You don’t want to be in a position where you have made a nice upside, only to find out that you are unable to offload your investment. Finally, you also need to ensure that you have a full understanding of the underlying fees. As alternative investments typically cost more to access, you need to make sure that this fits in with your long-term investing goals.
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Ricardo is an entrepreneur, investor and personal finance nerd who enjoys spending time with his family and friends, travelling and helping others achieve their financial goals. Ricardo has been quoted as a personal finance expert in several online publications including Healthline, Bankrate, GOBankingRates, MSN Money, Yahoo Finance, U.S. News & World Report, Forbes and USA Today.