Alternative investments can add depth to your portfolio, but they come with notable risks. Find out whether alternatives have a place in your portfolio with this guide. You'll learn the main types of alternatives available, their advantages and disadvantages, how to invest in them, and how much alternative asset exposure experts recommend.
Understanding alternative investments
Alternative investments are nontraditional financial assets. They include things like real estate, cryptocurrencies, collectibles, and private equity that fall outside the conventional categories of stocks, bonds, and cash.
Wealthy, accredited investors use alternative assets to diversify their exposure beyond the traditional financial markets. Nonprofessional investors, however, have less access. When alternative assets are available to nonaccredited investors, the lack of pricing transparency and regulations can be off-putting for those with limited resources.
Types of alternative investments include:
- Real estate. You can purchase physical property or securities that invest in physical property, including exchange-traded funds (ETFs) and real estate investment trusts (REITS). Real estate can provide rental income and capital gains through appreciation.
- Cryptocurrencies. Digital currencies including Bitcoin (BTC -0.26%) are available for purchase through exchanges like Coinbase (COIN -5.40%). Cryptocurrency values can be volatile and unpredictable.
- Collectibles. Collectible investments include artwork, classic cars, fine wines, and memorabilia. These can have uncertain gain potential, especially in the short term.
- Private equity. Private equity is an ownership stake in a business that is not publicly traded. Often, the target company is a start-up.
- Private debt. Private debt investing involves lending money directly to individuals or businesses.
- Hedge funds. Hedge funds are untraded, pooled investment funds, usually available only to accredited investors. These funds often invest in alternative assets and use riskier strategies, such as leverage, to produce returns.
- Commodities. Commodities are raw materials that have enduring demand due to their utility. Precious metals are commodities, as are agricultural products like soybeans and grains. Commodity prices rise and fall with supply and demand around the world. Commodities traders look to gain from those trends.
Pros and cons of alternative investments
The advantages of investing in alternatives include:
- Diversification. Alternative assets can rise or fall independently of the financial markets. This means they can provide some shelter from stock market downturns.
- Return potential. Some categories of alternatives have high return potential, although they can be risky. For example, a private equity investment in a newly formed company could deliver huge gains if the business succeeds and goes public or is acquired.
- Inflation protection. Commodity price increases often precede broader inflation trends. For this reason, some investors use commodity exposure as inflation protection. If inflation undercuts their equity returns, they can see an offsetting benefit from higher commodity values.
- Hobby alignment. Collectors usually enjoy searching for and acquiring their favorite assets. To some, the thrill of collecting classic cars or artwork is more valuable than the potential for financial gain.
The disadvantages of alternative asset investing can be significant. They include:
- Lack of pricing transparency. Exchanges like the New York Stock Exchange (NYSE) and the Nasdaq provide complete pricing transparency for their assets. The ongoing record of a stock's price fluctuations provides clear documentation of what investors are willing to pay for that asset. By comparison, the value of a 1965 Ford Mustang or a 10% share in a start-up is more subjective. Paying too much or selling for too little can be the result.
- Volatility. Alternative asset values can change quickly and unpredictably.
- Illiquidity. Real estate and other physical assets take longer to sell than most exchange-traded stocks and fund shares.
- Lack of regulation. The Securities and Exchange Commission (SEC) regulates stocks and bonds, while the Office of the Comptroller of the Currency oversees banks that hold cash deposits. The markets for alternative assets have less oversight.
- High costs. Minimum investments and fees associated with alternative assets can be high. While you can buy a share of Nvidia (NVDA -0.61%) for less than $200, purchasing a nice real estate parcel costs far more.
- Inaccessibility. Hedge funds and formal private equity arrangements are mostly limited to accredited investors.
Steps to invest
Alternative asset investing requires discipline. Take a look at how Bitcoin's value has changed over the last year, and you'll see why: The volatility of this asset makes the S&P 500 look calm by comparison. To minimize your chances of costly mistakes, follow these steps to invest in alternative assets:
- Define your risk tolerance. Be honest about how much risk you can handle. You may decide alternative assets aren't for you.
- Set your goal. Are you interested in passive income or capital gains? The answer will limit your asset choices.
- Know your interests. Ideally, you will choose an asset type you enjoy researching. Research contributes to deeper expertise, which informs better decisions.
- Research your options. Spend time learning which alternative investments you can access and how each reacts to different economic conditions.
- Set an allocation. An allocation is a cap on the exposure you will accept for that asset. It is expressed as a percentage of your portfolio. Having an upper limit to your investment gives you a budget and helps you manage risk.
- Invest and monitor. Invest in your chosen asset according to your budget and monitor the performance. You may also want to define an exit strategy -- that is, the conditions under which you'd sell.
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Example allocations
Your alternative investment allocation -- the fifth step above -- influences your risk and overall experience with these assets. Expert-defined portfolios generally target alternative investment exposure at 0% to 20%. Three examples are below.
- All-weather portfolio by hedge fund manager Ray Dalio includes 7.5% in gold and 7.5% in commodities. The portfolio also includes 40% long-term bonds, 30% stocks, and 15% intermediate-term bonds.
- Aggressive growth Core-4 portfolio by author and advisor Rick Ferri includes 8% exposure to a U.S. real estate index fund. The remaining positions are 48% in U.S. stocks, 24% in international stocks, and 20% in U.S. investment-grade bonds.
- Warren Buffett portfolio, inspired by the famous leader of Berkshire Hathaway, does not include alternative assets. This portfolio is a simple but aggressive mix of 90% U.S. stocks and 10% short-term U.S. Treasury debt.
The percentage exposure you target is a personal decision, but starting low is usually best. You can always add to your position as you get comfortable with your alternative positions.
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