Alternative investments are crucial for portfolio diversification — and in some cases, they may rank among the best investments you’ll ever make.
Savvy institutional investors and high net worth individuals are shifting their exposure away from stocks and into alternatives such as real estate, private equity and cryptocurrencies to tap into new and diversified investment strategies. Alternatives offer both institutional and retail investors the potential for higher returns and also provide exposure to assets that are uncorrelated to public markets, which can shelter your portfolio during times of market volatility.
At my company, a retirement portfolio investment tool, I’ve seen scores of investors tap into their tax-advantaged savings to make investments in a wide range of alternative asset classes. While real estate remains one of the most common asset classes for these investors, many are using their retirement wealth to invest in cryptocurrencies, peer-to-peer loans, direct business equity and many more.
Alternatives can not only enhance portfolio diversification but also operate as a means to build substantial wealth. Four self-made millionaires recently described the best investments they ever made, and none highlighted traditional stock market investments.
One self-made millionaire received equity in AOL when it was just a fledgling tech startup, while another was an early stage investor in luxury shoe brand Jimmie Choo. One flipped commercial real estate, and the last capitalized on a small stake in Microsoft’s growth in the 1990s as well as California’s residential real estate bubble prior to the Great Recession. The common theme here is that all of these nontraditional investments ranks as the best investments these four ever made. Their stories aren’t about buying shares of Coca-Cola or General Electric in the 1960s, but rather how they amassed personal wealth through key alternative investments.
Although investing in alternatives such as tech startups can be a bit riskier than traditional stock market investments, the upside can be life-changing if you do hit that home run. Investing in more tangible assets such as real estate can provide more safety, and countless retail investors have leveraged initial investments in real estate to build significant portfolios of real assets that provide substantial wealth and monthly income.
Retirement investors can tap into wealth they’ve already accumulated to construct an alternative and private portfolio as part of their overall asset base. This diversified strategy means investors don’t have to bet on just one company and hope they hit a home run; they can bet across multiple asset classes such as direct equity investments into early stage companies, real estate and digital currencies.
Diversification into alternative assets could be essential to crafting a well-balanced 21st century portfolio that can withstand periods of economic volatility and generate substantial tax-deferred returns. The upside potential can pay dividends that investors typically won’t see with their standard market investments.
Unlike traditional investing in most publicly offered assets, where conservative investors can follow the traditional 80/20 or 60/40 rule and allocate the bulk of their portfolio to less volatile assets such as low-yield bonds and other fixed-income products and a more modest percent into riskier high-growth stocks, there’s no real road map for investing in alternative assets. That’s mostly because alternatives encompass such a wide range of investment options, from cryptocurrencies to oil and gas leases to real estate.
Two primary drivers for alternative investment allocation are the individual investor’s appetite for risk and his or her age. Older investors nearing retirement age aren’t as likely to allocate the bulk of their portfolio into private equity or other assets that have the potential to go bust. Younger investors, on the other hand, may be more comfortable allocating a significant portion of their investment funds into cryptocurrencies, private business equity, peer-to-peer loans or crowdfunding opportunities because they’re better positioned to weather longer hold times and cyclical downturns across their investments.
Alternative investors also would be wise to hedge their risk by spreading investments across a wide range of asset classes rather than single-stream investing, which can create a large amount of asset-specific risk. Diversification creates a buffer against cyclical swings in real estate, regional economies and downturns in public markets. Portfolios containing 15 to 20 assets can offer a greatly reduced risk profile, as well as increased opportunity for high-yield growth from several successful investments.
Investors should perform extensive due diligence on prospective investments to determine which alternatives are best for them since risk profiles vary greatly depending on the nature of the asset class. Primary concerns for private equity investments for startups, for example, include ensuring valuations are correct and stringent cash management principles are in place, the business has the potential to scale and executive management has the ability to execute. Some investors engage third-party risk aggregators to collect, process and analyze this vital information.
There’s no single approach that’s superior when it comes to alternative investing. Prudent investors often blend a range of traditional investments with a mixed portfolio of alternatives to improve expected returns and spread risk. Alternative investors also should consider their and personal expertise, familiarity and ability to execute within a given asset class. The alternative space continues to expand, and investment strategies should remain fluid in order to adapt to rapid change and new opportunities.