Updated: Apr 19
Investors frequently hear warnings of the perils of not diversifying their portfolios between stocks and bonds.
September 22, 2020 by Riley Adams
“In their truest sense, alternative investments represent a further diversification in your portfolio and often act as a buffer against volatility seen in the actively-traded securities like stocks and bonds.”
Investors frequently hear warnings of the perils of not diversifying their portfolios between stocks and bonds. While certainly two major asset classes you should consider when learning how to start investing money, other investment opportunities exist beyond traditional exchange-listed securities.
In fact, a truly diversified investment portfolio should also include “alternative investments.” By definition, these represent financial assets which do not fall into either of these conventional asset classes. For example, alternative investments include tangible assets like art, wine, gold, oil, real estate (like condos, single-family homes, commercial real estate, etc.), venture capital, royalties, tax liens, and much more.
In their truest sense, alternative investments represent a further diversification in your portfolio and often act as a buffer against volatility seen in the actively-traded securities like stocks and bonds. When it comes to choosing which alternative investment options make sense for your portfolio, you should consider:
their liquidity (i.e., how quickly and cheaply these assets can convert to cash if you need to sell),
how they fit into your budget,
investing time horizon (and patience level), and
Before discussing several examples of alternative investments you should consider, let’s first examine the primary pros and cons of investing in alternative assets.
Pros of Alternative Investments
As mentioned briefly above, alternative investments carry a number of positive elements for why you should consider making them part of your overall strategy on how to build wealth. Read below to see the primary reasons for including alternative investments in your portfolio and also keep in mind the various details related to each alternative investment differ. Therefore, not all of these elements will apply in each situation.
First and foremost, holding a diverse selection of assets decreases the likelihood of taking on asset-specific risk. Holding multiple types of assets reduces the possibility of exposing yourself to the risk of one investment adversely impacting your overall portfolio return. Many investors turn to alternatives as a way to create a more diverse portfolio rather than having everything wrapped up in stocks, bonds, and cash.
→ Higher Potential Expected Returns
Given the long-term nature of many alternative investments, their illiquidity offers a premium investors expect in exchange for losing immediate access to their funds. For the disciplined, long-term oriented investors, some alternative investments appear attractive simply because they offer higher expected returns which might not come from other investing strategies.
→ Not Correlated with the Stock or Bond Markets
Depending on the alternative investments considered, some do not have significant (if any) correlation with the stock or bond markets (at least directly). In other words, changes in the stock market should not directly affect the value of your alternative investment. Translation: alternatives can act as a valuable portfolio diversifier due to their potential for insulating your portfolio from day-to-day volatility during rough market conditions.
→ Tax Benefits
Alternatives vary with investment objective and return potential. Some provide income streams while others offer capital appreciation opportunities. Depending on the alternative considered, they may act as tax-advantaged investments worth examining in your evaluation. If you have uncertainty about their tax consequences, please consult a tax professional for advice related to your personal situation and the specific investments under consideration.
Cons of Alternative Investments
Now that we have examined the main reasons for why you would consider investing in alternatives, let’s also take a moment to address some of their drawbacks.
→ Risk of Loss
Every investment carries some level of associated risk. Alternative investments act no differently. Therefore, while the level of risk will vary from one investment to another, in general, alternative investments still carry risk.
Depending on the type of alternative asset, they may range in risk from conservative to aggressive. One other item to consider during your analysis are regulations or the lack thereof. While traditional investments like investing in index funds, stocks and bonds have deep markets and tightly-controlled rules and regulations (even something as risky as shorting stocks on Robinhood and Webull comes with strict rules and regulations), not all alternative investments come with such certainty.
As a result, rules and regulations will vary by investment and should factor into your risk evaluation. Investing in alternatives carries the risk of partial or complete loss in some instances.
→ Unfamiliar Assets and Risks
A major reason why alternative investments can carry more risk than more traditional investments stems from the fact that they tend to be less familiar to most investors.
As a general rule, you should avoid investing in anything you do not fully comprehend (e.g., credit default swaps).
Therefore, take time to conduct your own research into the asset before moving forward with an alternative investment. If you choose to invest without sufficient due diligence, you could potentially expose yourself to an undue amount of risk.
→ Tax Disadvantages / Complexity
Just as some alternative investments create potential for tax-advantaged investments, the same applies to the other side of the coin. Some alternatives offer tax disadvantages compared to other options available to you. As a result, you should consider speaking with a tax professional if you do not have certainty about the tax consequences of investing in an alternative investment.
→ Some Alternative Investments Require a High Minimum Investment
As with all investments, certain minimums could apply. Mutual funds, target date funds,, and other common types of investment vehicles often present hurdles in the form of minimum initial contributions before gaining access to investing in their funds. While index funds on Robinhood or the best Robinhood alternatives do not require minimum investments (beyond affording the price of purchasing one share), alternatives present different rules in some cases.