For investors seeking diversification, alternative investments can reduce portfolio volatility since they typically behave differently from traditional markets. Essentially, alternative investments are a broad range of asset classes that fall outside of traditional stocks, bonds and cash. This includes real estate, private equity, hedge funds, commodities and collectibles, among others.
One reason why alternative investments can be a valuable addition to a portfolio is that they often provide unique opportunities for growth and income, especially in low-yield environments. However, these investments can be complex and less liquid, which means investing requires thorough research and a longer-term perspective — and possibly the guidance of a financial advisor.
Understanding Why Alternative Investments Can Appeal to Investors
The major reason why alternative investments are appealing is their potential to offer returns that are not closely correlated with the stock market, effectively providing a hedge against market volatility. As such, investors often explore alternative investments to enhance their portfolio diversification.
Traditional assets like stocks and bonds can be heavily influenced by market fluctuations. In fact, during periods of economic instability, they may not perform as desired all the time. By including alternative investments, it’s possible to reduce overall portfolio risk and achieve more stable returns. This strategy is particularly beneficial in times of market uncertainty, as it spreads risk across various asset classes.
Investors also are often drawn to alternative investments because of their potential for higher returns. Private equity and hedge funds, in particular, have the capacity to generate significant growth, though they also come with their own risks and downsides.
Benefits of Alternative Investments
As suggested, including alternative investments in your portfolio can offer a number of benefits, such as:
- Diversification: By spreading investments across various asset classes, investors can reduce their overall risk. Alternative investments often have low correlation with traditional assets, making them an excellent tool for risk management, as they can help cushion a portfolio against volatility.
- Access to unique opportunities: Investing in alternative assets provides access to unique opportunities that are not available in the public markets. Real estate investments, for example, can offer both income and capital appreciation. Similarly, investing in start-ups or private companies through venture capital can lead to significant gains if the businesses succeed.
- Hedging against inflation: Assets like real estate and commodities tend to appreciate in value as inflation rises, protecting the purchasing power of an investor’s capital. This inflation-hedging characteristic makes alternative investments a potentially valuable addition to any portfolio, especially in times of economic uncertainty.
- Enhanced portfolio performance: Incorporating alternative investments can enhance the overall performance of an investment portfolio. By balancing traditional and alternative assets, investors can achieve a more robust and resilient portfolio, as the diverse nature of alternative investments can mitigate the impact of market downturns and enhance long-term growth prospects.
Risks and Downsides of Alternative Investments
As you’re weighing why alternative investments are — or aren’t — right for your portfolio, it is also important to take into consideration their drawbacks:
- Lack of liquidity: Unlike stocks or bonds, which you can sell relatively quickly, alternative investments often require a longer time horizon and have smaller sales markets and long sales times. Real estate properties, for example, can take months or even years to sell, tying up capital and limiting financial flexibility.
- Limited transparency and oversight: Alternative investments often lack the regulatory oversight of traditional financial markets. This can make it difficult for investors to fully understand what they are investing in and to accurately assess the associated risks. For example, the complex strategies employed by hedge funds may not be entirely clear to the average investor.
- High fees and costs: Hedge funds and private equity funds typically charge hefty management and performance fees. These expenses can make it challenging for investors to achieve the desired profit, especially when compared to more cost-effective traditional investments.
- Greater risk and volatility: Market risk and volatility are inherent to all investments, but they can be more pronounced in alternative investments. Commodities like oil or gold can experience significant price swings due to geopolitical events or changes in supply and demand. Similarly, the value of collectibles such as art or wine is highly subjective and can fluctuate based on trends and market sentiment.
- Not necessarily accessible or suitable for all: Many alternative investments require substantial initial capital, limiting their availability to wealthy individuals or institutional investors. Moreover, alternative investments may not be suitable for all risk profiles. Investors without a high tolerance for risk may find the volatility and potential for loss unpalatable.
Are Alternative Investments Right for You?
Before diving into alternative investments, it’s important to assess your risk tolerance, time horizon and other major characteristics as an investor. As mentioned, alternative investments can be highly volatile and tend to be less liquid than traditional assets. If you have a low tolerance for risk or think you may need quick access to your funds, alternative investments might not be a good fit.
On the flip side, if you can stomach their risk and lack of liquidity, alternative investments can enhance overall portfolio diversification. By spreading your investments across various asset classes, you can reduce the impact of poor performance in any one area. This can help to stabilize your portfolio and provide more consistent returns over time.
The tax implications of alternative investments are also an essential consideration for investors. Different types of alternative investments come with varying tax treatments. For example, real estate investments might provide tax benefits through depreciation deductions, while profits from hedge funds can be subject to significant capital gains taxes.
Given the complexity and risks associated with all investments — but especially those of the alternative variety — seeking professional advice could be worthwhile. A financial advisor can help clients determine whether these investments align with their financial goals, risk tolerance, horizon and more.
Bottom Line
Alternative investments, including real estate, commodities and hedge funds, can provide diversification beyond traditional stocks and bonds. They also have the potential to offer higher returns, particularly during periods of market volatility, which can make them an attractive option for seasoned investors seeking to enhance their portfolios.
However, alternative investments often require substantial capital, and they are usually less liquid than traditional asset classes, which means that converting them to cash can be challenging. Further, alternative investments may involve higher fees and more complex tax implications, demanding a thorough understanding and careful management.
Investing Tips
- A financial advisor can help you build a portfolio that consists of a wide range of investments. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- There are a number of different ways in which you can get involved in the alternative investment game. Here’s a breakdown of alternative investment platforms to consider.
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