What are alternative investments? Four of Them You Need to Know
Updated: Aug 18, 2020
Alternative Investments: A Beginner’s Guide
Whenever you invest your money into anything whatsoever, it falls into one or more asset classes. An asset class is a group of similar securities or investments that all behave the same and follow the same sets of rules and regulations.
All of the asset classes fall under one of two categories:
Traditional Asset Classes - These are asset classes that encompass the more traditional forms of investing. Stocks (equities), Bonds (fixed income), Cash, and Real Estate are some of the traditional asset classes.
Alternative Asset Classes - Unlike traditional assets, Alternative Asset Classes are going to encompass the types of investments that are traditional and even somewhat unexpected.
If you decide to give your friend $10,000 to start a business in exchange for 50% ownership, that’s an example of an alternative asset investment. Bitcoin is an alternative asset. Foreign exchange currency trading (FOREX) falls under alternative asset classes.
These are, of course, just a few examples. There are many more alternative asset classes than there are traditional asset classes. This is, in part, because new types of investments and investing strategies are popping up as technology changes. Over a decade ago, nobody knew what cryptocurrencies were, and they’re now in their own class of investments.
Alternative Asset Classes vs. Traditional Asset Classes
Alternative asset classes used to only be available to institutional investors. A large corporation that has someone investing to grow their employees’ pension funds, for example, would be one of the few entities that could invest in alternative asset classes. Leaving smaller entities and private investors only being able to invest into traditional asset classes like stocks and bonds.
A few decades ago, namely as Wall Street and other markets around the world started to embrace technology, some of these alternative asset classes became accessible to those smaller entities and private investors that were not able to take advantage of them before.
Over the last decade or so, the doors to alternative asset classes have swung wide open. With the digitization of the investing world, anybody can pick up their smartphone or open up their laptop and start investing in asset classes that were once closed off to most of the world.
4 Examples of Popular Alternative Asset Classes
Because of the sheer number of investment possibilities with regards to alternative asset classes, it would be nearly impossible to make an exhaustive guide that covers every single asset class. Having said that, we can cover some great alternative asset classes that we think would make wonderful additions to any portfolio, especially those of high net worth.
1. Private Equity Investments
Whenever you buy and sell shares of stock on the stock market, you are buying a piece of a publicly traded company. Investing in owning a portion of a private company is a Private Equity Investment.
Just like when you’re dealing with stock from publicly traded companies, there are risks that come into play based on how well the company performs. Private equity investments carry a slightly greater risk than trading a publicly traded company. However, this also means that they have a potential for much higher returns.
With publicly traded stocks you can usually only profit from dividend payments or you can profit from selling the shares for more than you paid for them as the value of the company rises. Private equity investments are more likely to engage in profit-sharing programs, which provides one potential form of income.
Private equity investments also commonly take place when a company gets purchased, revamped, and resold at a profit. Your profit from the sale of said company is based on how much ownership you had.
Liquidating private equity investments are not quite as easy as opening up your stock-trading app to sell your shares instantly during market trading hours. If the private equity investment was from a leveraged buyout, for example, you may not recoup your original investment until the newly revamped company gets sold for a profit.
2. Hedge Fund Investments
The original idea behind hedge funds was that they would be designed in a way that would let investors ‘hedge’ their funds to mitigate the risk associated with market uncertainty. The entire goal around hedge fund investing is to mitigate loss, preserve capital, and maximize returns and profits along the way.
Hedge funds, simply put, are a collection of investment securities. Are hedge funds the same as mutual funds? Well, not exactly. While both of these investment options have “pooled” securities grouped together, there are a few key differences. These differences also paint a good picture about what investors can expect from a hedge fund
Hedge Funds vs. Mutual Funds:
Mutual Funds are publicly bought and sold. Most hedge funds are not registered with the SEC and are carefully selective with who is allowed to invest.
Hedge Fund managers have much more flexibility when it comes to selling short, using leverage, or using derivatives, for example.
Historically, many hedge funds that have their data made available publicly are shown to outpace market averages when compared to mutual funds. (potentially higher reward)
The risk with hedge funds is also higher because they are not as tightly regulated. Your returns are up to that of the hedge fund manager(s).
Mutual funds offer daily liquidity when the markets are open, but hedge funds have provisions in place, known as ‘lockup provisions’, that will dictate certain periods when you are able to access your money.
3. Investing In Commodities
Anything necessary to maintain our quality of life, or to manufacture things needed for our quality of life, can be considered a commodity. Oil and natural gas are commodities. Gold and silver are commodities. Even items like wheat and pork belly are considered commodities.
Commodities are often seen as risky investments, especially when compared with traditional asset classes like stocks and bonds. However, these risks and volatility involved with bonds oftentimes mean that the potential for reward is much greater. Beginning investors often severely underestimate the inherent risks involved with commodity investments
The liquidity of commodity investments will vary depending on which specific commodities you’ve invested in. Precious metals, like gold and silver, are fairly easy to liquidate, especially if you’ve invested in physical bullion. Other commodities, such as cattle, are much harder to liquidate.
4. Life Insurance Investments
Whenever you pay your monthly, semi-annual, or annual premiums on a whole life insurance policy, a portion of that payment goes to insurance while the rest of it goes into an interest-bearing account. This, at its core, is an investment. This account goes up in value just like a retirement account or any other long-term investment.
The potential reward doesn’t exactly stack up next to the other asset classes we’ve listed so far, but that’s okay. The risk is extremely low. The low risk makes it a great long-term investment, almost in the same class as a retirement account. And, just like many traditional retirement accounts, the cash-value of a whole life policy is tax deferred.
Whenever it’s time to withdraw the cash value from your whole life policy, that’s when you will pay taxes. You will also be subject to any fees that your insurance company should have outlined in your original insurance papers.
If you need to access the cash value but don’t want to risk dipping into your potential retirement nest egg, you can always take out a loan against the cash value of your whole-life policy. But that is another topic for another day.
The Higher Your Net Worth, The More You Need Alternative Asset Classes
The age-old cliche “Don’t put all of your eggs in one basket” constantly rings true throughout the world of investing. Diversifying your portfolio is one of the most important investment decisions that you could ever make.
Many common, everyday investors will have a portfolio that is diverse with different stocks, bonds, ETFs, money market accounts, or certificates of deposit. And while that diversification might work for the average consumer, it would be a bad decision for a high net worth individual.
All of those investments we listed in the paragraph above are Traditional Asset Classes. And, again, for most people that’s okay. But someone with a high net worth will want to spread their investments out across both traditional and alternative asset classes.
Increased wealth often goes hand in hand with increased complexity when it comes to investment portfolios. A high net worth individual facing market volatility with a large portfolio of traditional assets will want to have alternative asset classes in place to mitigate any potential risks.
Many private equity and hedge fund investments are selective with who they let invest in their operations. In fact, many investment opportunities are only open to Qualified Investors (individuals with a portfolio of $5MM or greater)
The right mixture of alternative assets may provide higher returns than bonds while being more stable than most stocks. High net worth individuals that have a portfolio of $5MM or greater are more likely to invest in alternative assets. In fact, as of the most recent data available from 2019, nearly 2/3rds of these investors use alternative assets to diversify their portfolio.
Even if you’re not a 7-figure investor, you may still benefit from these alternative asset classes. They’re a great way to protect against inflation and to protect against dips in the traditional asset markets.
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