Young investors often assume that investing is strictly limited to the stock market. Yet, while this is where most investing happens, there is a whole galaxy of investment vehicles beyond the more typical stocks and bonds that everyone talks about.
Known as “alternative investments,” these opportunities represent a completely different approach to investing and will be the focus of this week's post.
What Are Alternative Investments?
Alternative investments cover a broad swath of investing options, ranging from tangible assets like art, antiques, wine, stamps, and coins to financial assets like private equity in businesses, derivatives, commodities, and venture capital.
The common theme linking all of these together? With a few exceptions, these alternative investments are not traded on structured public markets like the Dow Jones or NASDAQ. Rather, they are traded either privately or through loose, informal networks of like-minded investors (such as on eBay or Craigslist, or business-buying websites).
Why Buy Alternative Investments Instead of Traditional Stocks and Bonds?
There are as many reasons for buying alternative investments as there are people who buy them. Most commonly, though, alternative investments are seen as a way to diversify against potential downturns in the valuations of traditional investments.
Take antiques as just one example. There is little (if any) correlation between the value of rocking chairs or porcelain vases and the share prices of, say, General Electric. They are subject to vastly different market forces and thus it is entirely possible for one to go up in value while the other goes down (and vice versa).
Thus, the mindset of a person buying alternative investments is typically this: If my stock portfolio takes a hit, at least I have these other investments — which hopefully will hold their value or not fall as much — to hold me over. That’s what the investor is hoping, but it may not be what actually happens when their theory is put to the test.
Important Things to Consider Before Buying Alternative Investments
We’ve already discussed how the values of alternative investments have low correlation with typical financial investments like stocks or bonds. However, there are other differences to consider before making these unique investments a substantial part of your portfolio.
Alternative investments are often less liquid than traditional ones. If you want to sell your shares in a company like GE, there’s no uncertainty or waiting. You just log into your E*TRADE account and sell. But who do you call if you want to sell an antique jewelry box? Sure, you can list it on eBay or bring it to an flea market, but these are not guaranteed liquidation mechanisms. It could take weeks, months, or even years to sell your asset for spendable cash.
- Determining the market value of an alternative investment is not always cut-and-dry. A key advantage of sophisticated, structured markets like NASDAQ is that prices are always visible. The constant buying and selling activity assigns very firm asset values to every share traded, such that there is never any doubt as to what something is worth. How can you be so sure what a 200-year-old bottle of wine (or 10% of your uncle’s lawn care business) is worth? Sometimes, you can’t be. The subjective “he said, she said” nature of alternative investment valuations can pose serious problems for those unfamiliar with the process.
- Risk and return data is often limited. Stock market investors can pull up decades of data about the ups and downs of just about every company on the market. This helps them make intelligent decisions about what to invest their money in. Unfortunately, this type of data is rarely available (at least not without painstaking research) for some of the alternative investments we’ve been discussing. Without this historical background, your decision to buy stamps or coins is basically a subjective judgement call.
- Transaction costs tend to be much higher. Another major benefit to traditional investing is standardization. Generally speaking, it costs as much to buy 10 shares of Company X as it does to buy 10 shares of Company Y, because of how streamlined and standardized the major exchanges are. On the other hand, there’s no telling what it will cost to buy a stamp collection from someone 2,000 miles away, or what a business will charge you for 15% of their equity. You might have to hire lawyers to make sure these unique transactions go off without a hitch — which adds to the transaction costs significantly.
Who Uses Alternative Investments?
It’s easy to stereotype and think that the only people using alternative investments are crackpots and survivalist kooks. But the data actually shows a different conclusion. According to a 2008 report by Merril Lynch, individuals defined as “high net worth” have as much as 9% of their financial assets in alternative investments including “structured products, luxury valuables and collectibles, hedge funds, managed futures, and precious metals.”
In other words: Some of the most sophisticated and financially successful people in the world have chosen to make alternative investments a substantial (albeit small) percentage of their investment portfolios.
Should You Add Alternative Investments to Your Portfolio?
Unfortunately, there is no one-size-fits-all answer. It all depends on your current situation, financial goals, and the resources at your disposal.
For instance, if you are new to investing and have never owned a single share of stock, it probably doesn’t make sense to start out buying coffee beans or old clocks. Instead, get your feet wet with an index fund — something that will expose you to the process of investing with minimal risk and manual intervention on your part.
However, let’s say you’re a more established investor with a robust portfolio. If your asset allocation is already in good shape, then devoting 5%–10% of your assets to alternative investments can be a terrific diversification hedge.
The key is to keep in mind the potential obstacles discussed above. Do not buy these assets with the same mindset or expectations that you would have of stocks. Understand that there could be a worst-case scenario where you could not easily sell an alternative investment. Do your best to see them as long-term assets rather than something to abruptly cash in on when the spirit moves you.
Do you invest in any alternative investments in your portfolio?