For one reason or another, many of us will occasionally turn our gazes to alternative investments. We may have grown impatient with our stock portfolio or been dazzled by spectacular performance in some niche sector, or we have been persuaded by some breathless email or newsletter. In any case, it's worth remembering that many alternative investments are not as great as they may seem, and some are rather dangerous.
First, though, what exactly is an alternative investment? Well, conventional investments include stocks, bonds, cash, and savings accounts, to name a few. Now let's review a handful of alternative investments and what makes them riskier than investors may realize.
Although they are stocks, penny stocks are something of an alternative investment because they're a unique kind of stock with particular qualities. Penny stocks are tantalizing to naive investors who love the idea of owning 20,000 shares of a stock for a total of just $1,000. They don't appreciate that a $200-per-share stock might in fact be a better bargain and that they'd be far better off spending that $1,000 on five shares of it. Penny stocks are often tied to extra-risky, unproven companies with captivating stories (a cure for cancer! An imminent big oil discovery!), no profits, and armies of con artists making money by hyping them up and then selling them. Remember that a $2 stock can quickly become a $0.20 one -- and often does.
Investing in gold is not a new idea, but the precious metal is volatile and doesn't have the best long-term track record. Wharton Business School professor Jeremy Siegel's data shows that while gold delivered an inflation-adjusted average annual return of 11.8% between 2000 and 2012, it averaged close to 2% between 1926 and 2012. Many choose it as a hedge against inflation, but it doesn't always offer much protection. Over the past three years, for example, the SPDR Gold ETF (NYSEMKT:GLD) has lost an annual average of 9.3%. Over the past five years, it has averaged a 1% gain.
Further, as Warren Buffett has noted, gold is an "unproductive asset": While you can invest in companies that provide real goods and services for money, gold just sits there, with few practical uses outside of jewelry. Some think of it as a "safe" investment, but its value fluctuations are unpredictable.
It might seem as if hedge fund investors are making big money, but that's often not the case. In 2014, for example, they gained about 2%, on average, while the S&P 500 advanced about 14%. Most of us can't invest in hedge funds period, as they tend to be restricted to "qualified investors" who are generally wealthy. Investors are typically charged "2 and 20," meaning they fork over 2% of their invested assets each year as a management fee (whereas managed stock mutual funds charge fees closer to 1%, while index funds frequently charge less than 0.25%), and then they also fork over 20% of any gains. Ouch.
The rationale for the high fees is that hedge funds deliver outstanding returns -- except many of them don't. Some are charging less these days, but even half of "2 and 20" is exorbitant. You can get great performance for far less.
If you want to buy a home in order to have a nice place to live, go right ahead. But if you're thinking of your home as a great investment, think again. Nobel-prize-winning economist Robert Shiller is famous for his studies of the housing market, and per his data, housing prices have grown at a compound annual rate of just 0.3% over the past century (inflation-adjusted), while the S&P 500 has averaged roughly 6.5%. And that's just an average; those who bought in the wrong places at the wrong time fared even worse.
Worse still, real estate has some big drawbacks compared to, say, stocks. For one thing, you can't liquidate a home quickly, and you can't sell off part of your home in order to generate some needed funds. If you're thinking of buying property in order to rent it out, give a lot of thought to how easily you'll take to being a landlord and dealing with late-night emergency repairs and tenants who don't pay. It's not for everyone, and when you crunch the numbers, it may not even be that lucrative for you.
Those who recommend investing in commodities -- i.e., raw materials or agricultural products such as grains, pork bellies, oil, copper, coffee, and sugar -- often explain that they offer diversification and a hedge against inflation. On the other hand, they commodities be very volatile. They're about twice as volatile as an S&P 500 index fund (remember that the S&P 500 is capable of big drops, too -- such as its 37% plunge in 2008) and nearly four times as volatile as a bond fund benchmark. You can lose a lot of money in commodities, especially if you're not familiar with them.
The foreign exchange market, or "Forex," has attracted many investors with its steep leverage capabilities. Whereas you can only have 2-to-1 leverage in stocks, you can have 50-to-1 in foreign currencies. This means you can make a lot with a little -- and you can also lose a lot more than you may realize you're putting at risk. You're also involved in making bets on currencies, and you may not understand interest rate movements, global economics, or how the fast-moving, volatile market works well enough to succeed in it.
Let's end with collectibles, as some people out there are filling drawers and cupboards with baseball cards, comics, wines, coins, and so on. Such collections might give you great pleasure, but they won't necessarily make you rich. Again, you need to research and understand the market on a deep level. Rare items can indeed develop great value, but many items produced today are produced in great quantities, making them less likely to fetch much in the future.
There are other alternative investments out there, too. Remember that oftentimes, what seems too good to be true is simply not true. Money can be made in many alternative investments, but those investments shouldn't be taken lightly. Fortunately, though stocks are pretty "mainstream," they've nonetheless made a lot of people wealthy over the long run.