Alternative investments like real estate, commodities, and hedge funds often perform differently from stocks and bonds, offering useful diversification benefits. They also have the potential for higher returns. However, they come with downsides, such as reduced liquidity and limited information. Working with a financial advisor can help you analyze different alternative investments and manage risks.
What Are Alternative Investments?
Alternative investments are financial assets that fall outside the traditional categories of stocks, bonds and cash. Common examples include real estate, private equity, hedge funds and commodities. Alternative investments may also include collectibles like art and wine.
Alternative investments often have a low correlation with standard asset classes such as stocks and bonds. This means that when traditional markets are volatile, alternative investments might not be as affected. Adding diversification to a portfolio in the form of alternative investments can reduce the impact of market declines affecting the more usual asset types.
However, alternative investments are often less liquid than traditional assets, meaning they can be harder to sell quickly if needed. Additionally, they may require a higher level of expertise to manage effectively, and their performance can be more difficult to evaluate due to a lack of standardized reporting.
Benefits of Investing in Alternative Investments
Investing in alternative investments can offer benefits that traditional assets like stocks and bonds may not provide. Here are five ways you can benefit from adding alternative investments to your portfolio:
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Portfolio diversification: Alternative investments often have a low correlation with traditional asset classes, meaning they can perform differently under the same market conditions. This diversification can reduce overall portfolio risk and volatility, providing a more stable investment experience.
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Potential for higher returns: Many alternative investments offer potential for higher returns compared to traditional investments. For example, private equity and venture capital can yield significant profits if the companies they invest in succeed. However, these higher returns often come with increased risk.
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Inflation hedge: Certain alternative investments, such as real estate and commodities, can act as a hedge against inflation. As the cost of goods and services rises, the value of these tangible assets may also increase, helping to preserve purchasing power.
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Access to unique opportunities: Alternative investments can provide access to opportunities that are not available in public markets. This includes investing in early-stage companies, distressed assets, or niche markets, which can offer distinct advantages and growth potential.
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Tax benefits: Some alternative investments come with tax advantages. For example, real estate investments may offer depreciation deductions, while certain energy investments can provide tax credits. These benefits can enhance the overall return on investment.
Potential Risks of Alternative Investments
Alternative investments also come with a set of risks that investors should carefully consider. Here are four to keep in mind:
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Lack of liquidity: One of the primary risks associated with alternative investments is their lack of liquidity. Unlike stocks and bonds, which can be easily bought and sold on public exchanges, alternative investments often require a longer commitment period. This means investors may not be able to quickly access their funds in an emergency.
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Complexity and transparency issues: Alternative investments can be complex and difficult to understand, even for seasoned investors. They often involve intricate financial structures and strategies that are not always transparent. This lack of transparency can make it challenging to assess the true value and risk of the investment.
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Higher fees and costs: Investing in alternatives typically involves higher fees and costs that reduce returns. These can include management fees, performance fees and other administrative costs that are higher than traditional investments.
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Regulatory and legal risks: Alternative investments are often subject to less regulatory oversight than traditional investments. This can expose investors to additional risks, such as fraud or mismanagement. Thorough due diligence to compliance with relevant legal and regulatory standards is doubly important.
Bottom Line
Investing in alternative investments can diversify your portfolio and potentially enhance returns. One reason is that alternative assets including real estate, private equity, hedge funds and commodities often behave differently from traditional stocks and bonds, and provide a hedge against market volatility. However, they can be less liquid and may require a longer commitment to realize their full potential, making them best suited for investors with a long time horizon.
Tips for Investment Planning
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A financial advisor can help you evaluate investment opportunities and maximize returns. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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When you sell assets that have appreciated in value, you may owe capital gains taxes. Use SmartAsset’s capital gains tax calculator to estimate the tax bill.
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