Like so many things in life, balance is important in your investment portfolio. Diversification is a concept that is important to understand when it comes to setting up and managing your investments. Balancing your portfolio with a range of investments diversified across different asset classes and within each asset class spreads your risk and makes you less vulnerable to the effects of particular events or circumstances.
Alternative investments can be a good way to diversify your investment portfolio.
What Are Alternative Investments?
The term ‘Alternative Investments’ broadly refers to any investment that is not publicly traded, meaning they sit outside of the traditional markets of stocks, bonds, and cash. Alternative investments provide an opportunity to gain exposure to different market sectors and potentially achieve higher returns than traditional investments.
But it is important to note that they generally come with greater risk and increased complexity, so doing your due diligence and educating yourself is vital to increase your knowledge and ensure you understand what you are getting into. One objective of alternative investments is to be invested in an asset class that is not highly correlated with the traditional market, with the idea being that if for example the stock market goes down, then your alternative investment does not necessarily follow that downward trend.
Alternative investments are mostly unregulated, so there is less protection for investors than with traditional investments. Often, alternative investments are limited only to accredited investors, because of their high-risk nature.
Types of Alternative Investments
There are many different types of alternative investments, each with their own pros and cons. Deciding on which one is right for you will depend on a range of factors and your own personal circumstances, so it is important that you do your research to discover what is a good fit for you. The following provides a (non-exhaustive) list of some types of alternative investments:
- Private equity, where you invest in private companies that are not publicly traded.
- Venture Capital (VC), which is a category of private equity where you invest in startup companies through a managed VC fund.
- Angel Investing, which is also a category of private equity where you invest in startups similar to VC but is a more flexible process with lower investments and can be accessed by individuals using angel investing platforms such as Propel(x).
- Private debt, where you lend money directly to a borrower with special conditions and higher interest rates than regular credit markets.
- Real estate, either as a direct holding of specific properties, or through a vehicle such as a Real Estate Investment Trust (REIT) or even through property crowdfunding.
- Precious metals such as gold or silver.
- Cryptocurrencies such as Bitcoin or Ethereum.
- Commodities such as crude oil, wheat, or coffee.
- Hedge funds, which are investment vehicles that use non-traditional investment strategies such as options and futures.
- Art, where you buy and hold fine art that has the potential to increase in value over time, either by direct purchase of specific pieces or through a specialized fund.
- Fine wine, where you purchase particular vintages that have the potential to grow in value.
- Collectibles such as baseball cards, comic books, stamps, coins, memorabilia, or cars (rare, classic, vintage, or antique).
In the past, access to alternative investments has been limited and so was often ignored. New technology and new platforms such as angel investing platform Propel(x) are providing investors with access to alternative investments.
One objective of alternative investments is to be invested in an asset class that is not highly correlated with the traditional market, with the idea being that if for example the stock market goes down, then your alternative investment does not necessarily follow that downward trend.
Do you need Alternative Investments?
When interest rates are low, this limits the financial returns on traditional fixed income investments such as bonds and cash. And if the stock market is at historical highs (as it has been lately), then there is limited upside potential. So, alternative investments provide the opportunity for exposure outside of those traditional investments, with the possibility of exceeding the market returns and with greater portfolio diversity to protect downside risk.
With a diversified portfolio, if the value of some assets goes down, the value of some other assets in your collection may rise, so the positives will hopefully balance out the negatives. It is important to understand that all types of alternative investments are not suitable for all investors. Depending on the type of asset class, some alternative investments are limited to accredited investors, qualified purchasers, and high-net-worth individuals. And some alternative investments have a higher degree of complexity, which is not suitable for everyone.
How much should be in Alternative Investments?
When considering the balance and diversification of an investment portfolio, it is important to establish how much should be in the various asset classes, including traditional and alternative investments. These articles Angel Resources provides guidance on angel investments and the potential mix between different asset classes.
A good place to start is to think about the risk / return ratio. Generally speaking, the opportunity for higher returns comes with higher risk. When seeking higher returns, it is important to realize that you could lose some, or all, of your investment and that the investment is not liquid The next thing to think about are your personal circumstances, including factors such as your age, the amount of capital you have to invest, your ability to generate income outside of your investments, your risk tolerance, etc.
All these factors influence how much is appropriate to allocate to alternative investments. When considering VC funds or angel investing, a sensible strategy for many individuals would be to allocate only a small percentage of their investable assets to startups, for example perhaps somewhere between 5% and 10% of investable assets. Of course, this will vary between individuals, and each must judge their own financial situation. Retaining the focus on investing in startups as an example of alternative investments, the question of “How much?” also needs to be supplemented by the question of “How many?”. Because this is where diversification comes in. While there is the potential for high returns in startup land, there are also many failures. Just putting your money into one startup is an extremely risky strategy. In general, investing in at least 20 startups may be a good strategy, because this spreads the risk and diversifies the startup portfolio.
With a diversified portfolio, if the value of some assets goes down, the value of some other assets in your collection may rise, so the positives will hopefully balance out the negatives.
Key characteristics of Alternative Investments
As discussed above, alternative investments encompass a broad range of assets and strategies. Key characteristics of alternative investments include:
- Potential for higher returns than traditional investments.
- High risk.
- Often illiquid, meaning they can be difficult to sell.
- Typically have a low correlation to stocks and bonds, which provides the potential for the alternative investments to not be badly affected when traditional markets are suffering.
- The investment structure, or investment vehicle, can be complicated.
- Limitations on when you can sell your investment because of a “lock-up period”.
- Minimum investment amounts often apply.
- Investments are often complex, requiring more research, education, and due diligence than traditional investments.
Regulation of Alternative Investments
Alternative investments are mostly unregulated, so there is less protection for investors than with traditional investments. Often, alternative investments are limited only to accredited investors, because of their high-risk nature. Some alternative investments have requirements for information disclosure, and the opportunity to ask questions, but this does not provide protection if you do decide to go ahead and something goes wrong.
Pros and cons of Alternative Investments
All investments have their pros and cons, and so do alternative investments. The pros and cons of alternative investments are closely linked to their key characteristics as outlined above, and are summarized below:
Pros: Potential for higher returns, diversification, exposure to unusual opportunities (such as investing in a tech startup), and low correlation to traditional markets. There is also the opportunity for investments of passion, where individuals can make a difference and contribute to a cause that is meaningful to them, for example investing in a startup working in sustainable agriculture or helping the environment. This can allow investors to participate meaningfully and contribute to entrepreneurship.
Cons: High risk, illiquid, long timeframe, complex, and the potential to lose the entire investment.
Why Alternative Investments can be a good choice
Suitable alternative investments can be a good choice to add to your portfolio because of the potential for higher returns. Taking investing in startups as an example, the most recent Angel Resource Institute’s 2016 Angel Returns Study on angel investing in North America showed average returns of approximately 22% per annum across multiple funds and investments. An appropriate mix of traditional investments and alternative investments in your portfolio could potentially lead to higher returns.
As with any investment, history is no guarantee of future performance, and any investment decision must balance the risk against the potential return.