Necessity for Alternative Investments in Your Portfolio
The term “alternative investments” refers to assets that traditionally have not been part of the average investor portfolio. The term refers to two sets of alternatives:
Alternative asset classes
Alternative investment vehicles
Portfolios can increase their diversification and reduce their riskiness by including alternative investments.
Portfolio Risk and Reward
If you are an investor, you probably have some expectations regarding the performance of your portfolio. Portfolio risk is the possibility that you will not achieve the performance you require. The two concepts, risk and reward, are inexorably linked – reward above the risk-free rate requires you to assume some risk. The risk-free rate is customarily thought of as the interest rate on three-month U.S. Treasury Bills. The ideal portfolio rewards you in the long run for taking on additional risk.
Systematic Risk and Diversification
Investors have long known the value of the old adage: “Don’t put all your eggs in one basket.” Diversification refers to the variety of assets in your portfolio and how closely they track the market portfolio. The market portfolio is theoretical and is made up of all the financial asset classes available for investment: stocks, bonds, currencies, commodities, etc. This portfolio is by definition well-diversified, and the different asset classes within it vary in their price correlation with each other. Low correlation of prices leads to lowered risk, since some assets appreciate while others lose value. The market portfolio has only systematic risks, which are the risks such as wars, recessions, inflation and interest rates changes that affect entire markets and cannot be diversified away.
Because markets don’t move in unison, it makes sense to allocate your investments over a wide variety of assets so that you limit your exposure to any one asset type. You can look beyond listed stocks to bonds, real estate, precious metals, commodities, private placements, and other alternative investments. You maximize diversification by including a variety of alternative investments.
Common Characteristics of Alternative Assets
In general, alternative assets share several characteristics:
These assets tend to be less liquid than standard financial instruments.
Low correlation with traditional assets such as exchange-traded stocks and bonds.
Valuation can be more an art than a science due to thin markets.
Historical data on risks and returns may be scarce.
Investors should perform extensive analysis before investing in an alternative asset.
Transaction costs may be high.
Alternative Asset Classes
In addition to cash, traditional financial assets include stocks, bonds, futures and options – all commonly traded either at auctions, exchanges or over-the-counter. Early work in Modern Portfolio Theory showed that alternative types of assets – ones with little correlation to traditional assets – could increase returns and lower risk when added to a traditional portfolio. Today, many savvy investors assign part of their wealth to various alternative assets, including:
Private securities - These are shares or bonds issued by private companies. Normally, you must be an accredited investor to buy these.
Precious metals – Including bullion, collectable coins, funds, and futures contracts.
Other commodities – Energy, grains, livestock and a whole range of different tangible items.
Rare items – Besides collectable coins, this group includes wines, stamps, antiques, trading cards and art.
Structured settlements – You can buy the payouts from winning lottery tickets or life insurance polices for a lump sum.
Oil and gas limited partnerships - Access to the profits from the output of oil wells and gas fields.
Equipment leasing – Cash flow from the leasing of capital equipment.
Real estate –Physical properties, farmland, timberland, or financial instruments backed by real estates, such as REITs. You can also invest in mortgage notes, mortgage-backed securities, tax deeds/liens, and collateralized mortgage obligations.
Alternative Investment Vehicles
Traditionally, investments were maintained in brokerage accounts, retirement accounts, mutual funds, or exchange-traded funds. For more affluent investors, the choices widen:
Hedge funds – Investment pools that use leverage, take short positions and invest in (often obscure) derivatives according to one or more investment strategies. Hedge funds only accept accredited investors -- $200,000 in income or $1 million in liquid assets.
Private equity funds– Investors who purchase private companies in the hopes of either extracting higher profits or liquidating at a profit. Private equity investors use leverage techniques and strict financial management techniques to increase the value of companies they buy.
Venture capital funds – Investors who help establish or support startup companies until these startups no longer need venture capital, as when a private company has an initial public offering.
In sum, investors can select from different alternative investments to increase their wealth while helping to protect against downside risk.
