Buzz
Getting started with investing is fairly simple. However, as you dig deeper into the process, many questions surface, making things more complex. You may have heard the term alternative investments, and if you’re just starting out, you might not know what it means. Let’s break it down in simple terms for the average investor.
What Exactly is an 'Alternative Investment'?
Imagine you’re investing for your retirement. You have a 401(k) that’s managing things for you, or perhaps you’ve got a solid mix of stocks and bonds within mutual funds. Either way, you're on a good path.
As your wealth increases, it’s time to take your portfolio to the next level. You’ll want to add more variety, because, over time, a diversified portfolio tends to yield higher returns. A well-diversified portfolio includes a variety of stocks and bonds—such as international stocks—and also incorporates alternative investments. Elliott Weir, Founder & Certified Financial Planner at III Financial, explains why these are crucial.
Including alternatives in your portfolio can add balance. Often, when stocks and bonds decline, other assets like commodities and real estate can increase in value. The term 'Alternative asset' refers to investments that are neither stocks, bonds, nor cash. This can encompass commodities (such as gold), hedge funds, collectibles, and real estate. These assets tend to be more complex, harder to assess, and less liquid than traditional investments.
Technically, your childhood collection of Beanie Babies qualifies as an alternative investment. However, to truly make the most of alternatives, you need to grasp their nuances and understand their workings more deeply.
Why You Might (or Might Not) Want to Invest in Alternatives
If you’re just beginning your investing journey or trying to catch up on retirement savings, you might not be too focused on alternatives. At this stage, you’ll likely want to concentrate on saving and building a simple, autopilot portfolio. But once your net worth starts growing, incorporating alternatives into your portfolio could be a good next step. Financial Samurai’s Sam Dogen explains why this is the case:
Once your net worth expands, consider allocating some savings into alternative asset classes by the time you’re 35. These could include private equity, venture capital, angel investing, or even starting your own company. You’ve got the basics—stocks, bonds, and real estate—covered. With more liquidity, you begin exploring new, uncharted territory, because you never want to wonder, 'What if?'
Once you reach 40, you’ll want to focus on achieving a more balanced approach to your net worth. This often means reducing your stock investments in favor of increasing your exposure to bonds and alternative assets. Additionally, your real estate holdings are likely to remain stable, assuming market conditions are favorable.
It’s crucial to remember: alternatives should not make up your entire portfolio. Their purpose is to complement and enhance your existing investments. While some investors may opt to focus solely on alternatives, such as hedge funds, Warren Buffett, widely regarded as one of the best investors of all time, cautions that they may not always be the best option, according to CNBC:
During the financial crisis, Buffett placed a $1 million bet with Protege Partners LLC, an asset management firm, that the S&P 500 would outperform a portfolio of hedge funds over the decade ending in 2017. As of Saturday, Buffett reported that the index fund has outperformed the hedge funds by nearly 44 percentage points over 8 years.
When the stock market takes a sharp downturn, however, many people tend to panic and, despite the data and better judgment, sell off their stocks and turn to alternatives like real estate, gold, or other commodities. These investments can certainly provide returns, depending on the timeframe you’re working with, but they are also volatile and not necessarily the best fit for long-term retirement planning.
For instance, gold prices surged during the 1980s and again during the Great Recession, but as The Motley Fool’s John Maxfield explains, this does not give the complete picture of gold’s investment potential:
The issue in both instances is that the price of gold quickly fell after it had risen so rapidly.
By 1985, the price had dropped to less than $600 an ounce. Since its peak in 2011, gold has lost more than a third of its value.
In order to profit from such price swings, an investor would need to time the market — something that’s known to be
risky
, and nearly impossible for the average investor to execute successfully.
In essence, alternatives can be useful for hedging and balancing your portfolio when the market experiences a downturn, but they shouldn’t be relied upon as the foundation of your investment strategy. They belong in your portfolio, but once again, they are not a substitute for it.
Determine the Right Portion of Your Portfolio to Allocate to Alternatives
We’ve explained how to determine your asset allocation—the portion of your funds to allocate between stocks and bonds. Here’s a simple guideline to follow:
110 - your age = the percentage of your portfolio to be allocated to stocks
For example, if you're 30 years old, you would allocate 80% of your portfolio to stocks (110 - 30 = 80) and the remaining 20% to safer, low-risk bonds. While this serves as a solid starting point, it doesn’t take alternatives into account. Most basic asset allocation calculators only consider stocks, bonds, and cash.
To calculate your alternative allocation, you might want to use an advanced portfolio analysis tool, like the (free) one we’ve mentioned before, Personal Capital. By linking your investment accounts, much like you would with Mint, Personal Capital instead reviews your portfolio and provides guidance on what asset classes, including alternatives, you should invest in.
I personally use this tool, and the image below illustrates how much of my portfolio is allocated to alternatives compared to other asset classes:
If you prefer a more straightforward approach, here’s a suggestion from Weir:
Generally, alternatives should make up a small percentage of a retirement investor’s portfolio. I recommend allocating around 3%-7%, depending on various factors. This is due to their inherent volatility and the relatively higher costs associated with owning them compared to stocks and bonds.
The factors Weir takes into account include your risk tolerance, the other assets in your portfolio, and how near you are to retirement. As you approach retirement, you’ll want to reduce your stock investments, shifting toward more bonds. You might also consider increasing your alternatives to help balance your portfolio.
Types of Alternative Investments Available
We’ve seen that alternatives are investments that provide strong returns and serve as a safeguard against stock market downturns. This category includes a variety of options, so let’s take a look at some of the most commonly used alternatives.
Hedge Funds
Historically, alternatives were not really intended for the average person looking to save for their retirement. The term hedge fund refers to one of the classic forms of alternative investment that many people have heard of.
When I think of hedge funds, I envision ultra-wealthy individuals instructing their financial advisors to handle millions of dollars. This view is valid, as up until recently, hedge funds were quite complicated and expensive, accessible only to the very wealthy or large institutions.
Hedge funds are composed of various alternative investments, sometimes investing in startups, or utilizing borrowed funds. They are designed to hedge against market volatility. Essentially, they aim to generate returns even when the market takes a dive, which helps keep your portfolio stable. Nowadays, you can access hedge funds in much the same way as a more affordable exchange-traded fund (ETF). However, hedge funds are not the only alternative investment option, and we'll explore more of them shortly.
In general, an alternative investment is one that operates independently of the market, offering reliable returns over time, even during market downturns.
ETFs and Mutual Funds
Hedge funds are a well-established form of alternative investment, but hedge fund ETFs and mutual funds can offer returns similar to those of traditional hedge funds. While these funds may still require a significant initial investment, it is often much lower than the millions typically associated with hedge funds. Like their traditional counterparts, these funds pool investments, but their primary purpose is to hedge against market fluctuations.
Real Estate
Apart from hedge funds and ETFs, real estate can also be a worthwhile alternative investment. You don't necessarily need to own physical property to benefit from it. Real Estate Investment Trusts (REITs) allow you to earn returns without having to be a landlord, and Weir recommends them as a good starting point for those interested in this type of investment.
Begin with a low-cost mutual fund focused on alternatives, such as Vanguard’s REIT Index Fund. This way, you leave the investment decisions to a professional team that understands the market dynamics. You can also
consult with a fee-only CFP® planner
to review your holdings and/or offer recommendations tailored to your best interests.
Precious Metals
Commodities such as gold or silver can also be a viable investment option. Similar to REITs, many prominent investment firms like Vanguard offer precious metal funds that you can purchase directly through your investment account. For example, Fidelity offers a gold fund called FSAGX.
There are also other unique alternatives. One option is peer-to-peer lending through platforms like Lending Club. I personally have around 1% of my portfolio in this area. While the returns aren't impressive for me, others have seen better success.
As with any investment, it's crucial to understand what you're getting into. This involves examining the return potential, long-term performance, and fees associated with your chosen alternative. According to Forbes, the fee for those high-end hedge funds can be as much as 2%. However, ETFs and mutual funds typically have much lower fees, usually under 1 percent.
Ultimately, the goal is to ensure your portfolio is well-diversified beyond just stocks and bonds. You want to see returns, which may involve taking on more risk. But that’s the advantage of a balanced portfolio: if one area underperforms, another can offset it and keep things stable.
Artwork by Sam Wooley.
