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There’s an old saying that “no one ever got fired for buying IBM.” Equivalent job security in the financial advisory industry has been built on the consistent recommendation for a portfolio allocated between stocks and bonds.
Is this still good and relevant advice for everyone? Are there any deviations or alternatives to this investing strategy? If you are interested in exploring alternative strategies and opportunities for your investments to produce growth, income, security, and more, this article is for you.
What are Alternative Investments?
Alternative investments are distinct asset classes that offer exposure and diversification outside of the traditional portfolio comprising stocks, bonds and cash. Many of these alternatives have historically been exclusively owned and traded between high net worth individuals.
There are exclusive benefits to investing in alternatives but there are also drawbacks and unique risks that could be avoided in public equities, debts, and currencies. Let’s discuss why one would look to include alternative investments in their portfolio and explore some of these potential investments.
Why Invest in Alternative Investments
There are many reasons why you should consider incorporating some alternative investments as a percentage of your portfolio, including diversification, risk parity, risk of economic stagnation and more.
Diversification and Risk Parity
As most experienced and educated investors would attest, diversification is an essential component of modern portfolio theory – at any scale.
Ray Dalio, the billionaire founder of Bridgewater Capital, is famous for his emphasis on risk parity in his “all weather” portfolio. Risk parity is a portfolio allocation strategy that advocates for investing in numerous uncorrelated assets which combine to reduce the entire portfolio’s risk of losing money.
Correlated assets move up or down together. For example, when a certain stock declines and related incumbents or even entire sectors decline in sympathy, these are proven to be highly correlated.
Alternative investments are often great opportunities to find uncorrelated positions that offer risk parity through adequate diversification.
Economic Stagnation
Another risk of investing entirely in traditional asset classes and not seeking exposure to alternative investments is recession and economic stagnation that can last for years or even decades.
The largest example is Japan’s lost decades. After their asset bubble burst in 1991, Japan experienced rapid decline and subsequent economic stagnation for more than two decades. Only in 2012 did the market begin a clear upward trend but has yet to match the previous record high set on December 29th, 1989.
Immense opportunity costs are associated with remaining fully invested in a stagnant asset class or market. If you include inflation rates in your return rate calculations, a flat market will actually cost you money since the purchasing power of the underlying currency will have decreased.
Types of Alternative Investments
There are a few reasons why one would seek to invest in an alternative investment:
- Yield/income
- Growth/appreciation
- Store of value/wealth preservation
The holy grail of investing is finding all three. Owning a rental property in a desirable and growing location, for example, would allow the investor to collect rental income, the underlying property value appreciation, and real estate has historically served as a reliable store of value.
Below is a list of alternative investments, and although many more certainly exist, we find these to be the most popular and accessible to modern investors:
1. Commodities
Investing in commodities, whether it’s precious metals, oil, livestock, agricultural or otherwise, can be a great way to diversify and manage volatility. Gold and silver, for example, typically see an increase in price when the stock market is declining and currencies experience inflation.
In many cases, retail investors do not want to take physical possession of the gold, silver, beef, grain, or other commodities, but wish to take advantage of the price action. This is possible through various instruments including futures contracts, options, and exchange traded funds (ETFs).
2. Venture Capital
Although the venture capital industry is a rather small sector of the global finance industry, the outsized returns of the top performing funds make it very attractive. Sovereign wealth funds, university endowments, and high net worth individuals have continued to grow their exposure.
Thanks to equity and debt crowdfunding tools, individual accredited investors are now able to take advantage of nearly the same opportunities to invest in promising startups. On EquityNet, for example, you can search from more than 10,000 companies actively seeking venture funding:
3. Real Estate
Although real estate does have a unique set of risks compared with stocks and cash, most notably illiquidity, it does offer investors many benefits including stability, diversification, and more.
Real estate investing assumes a long time horizon but most real estate investors buy property to collect rental income in addition to appreciating property value. The initial investment is relatively large which is why leverage (debt) is a common strategy employed by investors.
Today, however, you don’t necessarily need millions of dollars or unsustainable levels of debt to make lucrative real estate deals. Residential and commercial real estate investment platforms include:
4. Fine Art and Collectibles
The homes of high net worth individuals are typically filled with fine art, their wine cellars stocked with fine wine, and their garages replete with collections of classic cars, among other expensive collectibles.
It’s not surprising that connoisseurs of fine art, wine, and collectibles come from extraordinary means and therefore the rich are the only ones able to get richer from the equally extraordinary appreciation of their paintings and vintages.
Platforms for investing in fine art and other collectibles are finally allowing the average investor to gain exposure to these rare and traditionally inaccessible asset classes, including:
5. Cryptocurrencies
The newest asset class among alt investors is cryptocurrency, most notably Bitcoin. Bitcoin is a protocol for a uniquely scarce and decentralized digital currency that cannot be manipulated or counterfeited.
The protocol specifies a maximum supply of 21 million coins which offers investors a hedge against inflation (similar to precious metals), since the supply is theoretically finite, unlike the US dollar which can be printed, hyperinflated or devalued.
Other cryptocurrencies offer their own value propositions, such as Ethereum which is a smart contract blockchain but has its own nuances and risks. Collectively, cryptocurrencies run a high regulatory risk, among others we will cover next.
Regulation and Risk of Alternative Investments
In the world of alternatives, the ecosystem is constantly evolving and therefore risks can differ significantly from those of mainstream investing.
Securities trading in the US dates back to 1792, specifically war bonds and shares of the first bank of the United States stock. This means that lawmakers have had more than 200 years to find stability in the regulatory environment for stocks and bonds.
The internet has led to the creation of crowdfunding platforms, cryptocurrencies, and more that have and are likely to continue experiencing changes in regulations.
Forgery and Market Risk
In the market for collectibles such as fine art, wine, and others, the risk of forgery is certainly present. There have been high profile examples of counterfeit paintings and vintages selling for multiple millions of dollars, only to be reevaluated as fake and essentially worthless.
The value of collectibles is extremely subjective and can change significantly in either direction, which can make investments in art volatile and illiquid. Real estate, while less volatile, is certainly illiquid and subject to market risk, if the demand decreases and supply increases, the price of real estate will decrease.
Regulations and Schemes
In the world of alternative investments, new investment opportunities bring new opportunities for retail investors to be taken advantage of and lose money. Regulators are tasked with protecting the average investor from the perils of this ever evolving landscape which can add a level of risk to otherwise sound alternative investments.
Cryptocurrency, for example, has huge potential to disrupt global currencies, economies, and financial markets, and will likely experience a tightening of regulations. In 2017, a period of crypto frenzy and froth, bad agents were creating fraudulent Initial Coin Offerings (ICOs) and effectively stealing large amounts of money. It’s important that investors understand and research the intricacies of their investments and avoid buying out of FOMO.
Alternative Investments vs. Stock Market
We are certainly not advocating you ignore the stock market entirely (nor should you take any of this as investment advice). But historically speaking, if you ignored the S&P 500 market index and simply held US dollars, you would have missed out on the compounding returns of about 10% annually (and likely lost value to inflation).
Instead, we believe in the importance of diversification and risk parity. Own stocks when appropriate, own bonds when appropriate, and own alternatives when appropriate. If the stock market is overvalued and in a state of frenzy, start moving into cash or alternatives per the Warren Buffett quote, “Be greedy when others are fearful, and fearful when others are greedy.”
If you want to take advantage of investing in early-stage companies that could someday IPO on the public market, consider signing up to become an investor with EquityNet where angels, VC’s and other accredited investors like you go to source deal flow.
