If you are an investor who is looking to diversify your portfolio beyond stocks and bonds, alternative investment ideas are all around you. Investing in alternatives can be an effective way to reduce portfolio risk and volatility.
What’s more, they can increase your overall returns in the long term.
“Alternative” is a term that refers to any asset that does not belong to traditional asset classes such as stocks, bonds, and cash, as well as mutual funds that own these three types of common investments.
The most common examples of alternative investment ideas include hedge funds, private equity, venture capital, real estate investment trusts, commodities, and collectibles.
Key alternative investment ideas
Hedge funds are designed to produce consistent returns irrespective of the market conditions. Hedge fund managers invest money in a wide range of assets in an effort to generate returns even when the market is on a decline.
It is for this reason that hedge funds are sometimes called called targeted absolute return funds.
Private equity, as the name indicates, involves investing directly in private companies and buying out public companies.
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Most investors do not have the time or expertise to pick companies that are in alignment with their investment goals. So they invest their money through private equity funds, which are managed by professionals.
The people who manage the equity fund charge a fee as well as receive a share of the profits generated, while the bulk of the profits are distributed among the fund’s investors.
Venture capital is similar to private equity in the sense that it involves investing in private companies.
The difference is that venture capitalists mostly choose to invest in startups with high growth potential whereas private equity investors choose to invest in established companies with a good track record.
Venture capital is a riskier investment option compared to private equity, but the rewards are higher, too.
Real estate investment trusts
A real estate investment trust (REIT) is a portfolio of residential and commercial real estate properties. The properties are leased out and the rental income is divided among the investors.
The investors also stand to benefit from capital appreciation — an increase in the value of the properties — over a period of time.
The most common tangible commodities that you can invest in include precious metals (gold and silver), industrial metals (iron, copper, aluminum, lead, and so on), energy (oil), and agricultural commodities (wheat, sugar, soybeans, cotton, and so on).
The prices of these commodities are generally not determined by the performance of the stock market. Because of this they can prevent your portfolio from losing value during inflationary periods, as well as during market crashes.
The prices of commodities are driven mostly by supply and demand. They also tend to increase or decrease depending on the overall state of the economy, and geopolitical factors.
Collectibles such as artwork, vintage wine, antique items, rare coins, stamps, and vintage cars also make very good alternative investment ideas.
As is the case with commodities, the value of collectibles is not determined by market conditions.
Rather, the value of a collectible mostly depends on how well you have managed to preserve it and how much is the buyer willing to pay for it.
Why should you invest in alternatives?
Investing in alternatives allows you to diversify your portfolio, spread out the risk, and adds a layer of protection against market volatility.
Diversification, as you know, is the key to stable returns even under unfavorable market conditions and prevents your portfolio from losing too much value during a financial crisis.
Unlike traditional asset classes, the performance of alternative assets is not closely linked to stock or bond market conditions.
For example, the returns on managed futures, an integral part of alternative investment portfolio, have been more or less similar to that of stocks over the past 20 years.
At the same time, they were not affected by market volatility to the same extent as stocks did during the same time period.
Tangible assets such as gold tend to increase in value during turbulent market conditions, as people often sell their stocks in a panic and rush to buy physical assets during such times.
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Moreover, your art collection or wine collection does not decrease in value in the event of a stock market crash. The same rule applies to your stamp, coin, or antique collection.
The value of these assets is not determined by market conditions but by forces of supply and demand, availability of buyers, and the physical condition of the assets themselves.
The advantage of active management
Hedge funds and other such alternative investments need to be actively managed, as they are designed to generate consistent returns irrespective of the market conditions.
They are generally managed by the best minds in the industry, people whose expertise and experience drive the added value of the investment.
Factors regarding alternative investment ideas
Deciding market value
The value of a conventional asset such as a bond or stock is known to everyone.
The same cannot be said about certain kinds of alternative assets. For instance, how do determine the true value of a 100-year-old bottle of wine or a painting by an 18th-century artist?
There is a degree of subjectivity involved in determining the value of such items, which means you cannot be sure about the returns on your investment in some cases.
You can easily obtain volumes of data about the past performance of a conventional asset.
That is not the case with certain alternative assets, as the data might not be available or might be very hard to find. As a result, it can be difficult for you to make an informed decision.
High transaction costs
One of the reasons alternative investments are considered the domain of high net worth individuals is that the transaction costs are significantly higher compared to conventional investments.
Are Alternatives a Good Investment for You?
The answer depends largely on your financial situation and the performance of your portfolio.
If you are just starting to build an investment portfolio it is probably too early for you to dabble in alternative investments.
On the other hand, if you have a robust portfolio which has given you consistent returns, it might be a good idea to allocate at least a small portion of it, say between 5% and 10%, to alternative investments.