The Common Man’s Guide to Alternative Investment
It’s pretty easy to get started investing. However, if you delve into this, many questions arise that complicate the process. You may have come across the phrase alternative investment, and if you’re new to investing, you probably don’t understand what that means. Here’s a quick breakdown for the average personal investor.
What is “alternative investment”?
Let’s say you have invested money in retirement for years. You have a 401 (k) that does all the work for you, or you have a fair mix of stocks and bonds in mutual funds . Either way, you’re already doing pretty well.
However, as your net worth rises, it’s time to take your portfolio up a notch. You want to diversify it even more, because over time a diversified portfolio becomes profitable. A properly diversified portfolio includes different types of stocks and bonds, such as international stocks, and what are called alternatives. Elliott Weir, Founder and Certified Financial Planner at III Financial, tells us why they matter.
Alternatives can be helpful in a portfolio to provide some balance. Often (but not always), when stocks and bonds fall, assets like commodities and real estate can rise. “Alternative asset” is a broad term that includes assets other than stocks, bonds or cash. Examples include merchandise (like gold), hedge funds, collectibles, and real estate. These are often more complex assets that are more difficult to value and more difficult to convert into cash.
So technically your old collection of baby hats is considered an alternative. However, in order to properly invest in alternatives, it is worthwhile to understand a little more how they work.
Why you should (and should not) invest in alternatives
If you’re just starting to invest and are playing catch-up with your retirement, you may not be all that interested in alternatives. You just need to focus on saving and building a simple portfolio that you can customize and forget. However, when your net worth starts to grow, it might be time to add alternatives to your portfolio. Sam Dogen of Financial Samurai explains why:
With a larger net worth, you invest some of your savings in alternative asset classes by age 35. Alternative asset classes might include: private equity, venture capital / angel investors, or starting your own company. Your stocks, bonds and real estate have fallen in price. With free liquidity, you are immersed in the unknown because you never want to look back and say, “What if.”
After 40 years, you are looking for a more balanced home equity ratio. As a result, you are purposefully investing less in stocks and more in bonds and alternative investments. Your real estate capital also remains stable if the market is ready.
This is important: alternatives are not meant to replace your entire portfolio. They are meant to improve it. However, some investors will strictly invest in alternatives such as hedge funds . Considered the world’s greatest investor, Warren Buffett reminds us that it doesn’t really matter, CNBC reports :
During the financial crisis, Buffett had a $ 1 million bet with asset management firm Protege Partners LLC that the S&P 500 would outperform the hedge fund portfolio 10 years before 2017. Buffett said Saturday that the index fund outperforms hedge funds by nearly 44 percentage points. more than 8 years.
However, when the stock market drops significantly, people tend to go crazy and, contrary to common sense and statistics, sell their shares and turn to alternatives such as real estate, gold, or other commodities. While these investments can be fruitful depending on the time frame you’re looking at, they are also volatile and probably unwise for your retirement.
For example, gold prices skyrocketed in the 1980s and during the Great Recession, but John Maxfield of Motley Fool explains why this doesn’t provide the full picture :
But the problem with both of these cases is that the gold price soon fell as quickly as it rose before.
By 1985, it was less than $ 600 an ounce. And since its peak in 2011, gold has lost more than a third of its value.
Thus, in order to capitalize on these fluctuations, the investor will have to time the time in the market – which, as we know, is dangerous , if not impossible, for the successful average investor.
In other words, alternatives are great for hedging and balancing your portfolio when the market drops, but that’s about it. You should have them in your portfolio, but again: they are not meant to replace your portfolio.
Calculate how much of your portfolio should be in the alternatives
We’ve shown you how to calculate your asset allocation – the amount of your money that should be invested in stocks, not bonds. Here’s a basic rule of thumb:
110 – your age = the percentage of your portfolio that should consist of stocks
This means that if you were 30, you would invest 80% of your portfolio in stocks (110-30 = 80), and the remaining 20% in less-risk bonds. This is a good starting point, but it leaves out alternatives. And most major asset allocation calculators only include stocks, bonds, and cash.
To find an alternative percentage, you can use an advanced portfolio checker tool like the (free) one we wrote about earlier, Personal Capital . You simply link your investment accounts as if you did with Mint, but instead of analyzing your budget, Personal Capital analyzes your portfolio and tells you which specific asset classes to invest in, including alternatives.
I use this myself and the image below shows how much of my portfolio should be alternative to other asset classes:
If you’re looking for a simpler solution, here’s what Weir has to offer:
In most cases, alternatives should not make up a significant portion of a retirement investor’s portfolio. I recommend 3-7% depending on several factors, both because of their volatility and their relatively higher cost of ownership (compared to stocks and bonds).
The factors Weir mentions include your risk tolerance, other assets in your portfolio, and how close you are to retirement. Ideally, the closer you are to retirement, the less you want to invest in stocks. Your portfolio then goes into bonds, but you can also invest in other alternatives to balance the situation.
Alternative investment types to choose from
We learned that an alternative is investing with a solid return to hedge against the downturn in the stock market. This can be a big investment, but let’s take a look at a few of the most common ones.
In the past, the alternatives were not meant for the middle working class Jane, who simply wanted to save for retirement . You’ve probably heard the term hedge fund, which is a traditional alternative investment.
When I think of hedge funds, I think of the super-rich asking their financial advisors to transfer millions of dollars. And this is true, because until recently, hedge funds were complex and insanely expensive and only targeted very wealthy individuals or organizations.
Hedge funds are made up of many different alternative investments, sometimes they invest in startups, sometimes they use leveraged money, and are designed to hedge against market volatility. In short, ideally they generate income even when the market drops sharply, which keeps your portfolio balanced. These days, you can buy into a hedge fund just like you can buy into a cheaper exchange-traded fund (ETF) . However, hedge funds are not the only alternative. We will return to them later.
However, generally speaking, the alternative is an asset that is independent of the market and generates solid returns over time, even when the market falls.
ETFs and mutual funds
Again, hedge funds are traditional alternative investments, buthedge fund ETFs and mutual funds offer returns similar to the actual trade. They may still require a large minimum investment, but they are usually much more digestible than a few million. Like conventional mutual funds, they are made up of a pool of investments. In this case, these funds are intended to hedge the market.
Other than that, real estate can be a decent alternative and you don’t need to buy real estate to invest in it. Real Estate Investment Trusts (REITs) allow you to generate income without becoming a homeowner , and Weir also offers them as a starting point:
Start with a low-cost mutual fund that specializes in alternatives like the Vanguard REIT Index Fund. This will leave investment decisions to the discretion of a team that understands how this market functions. You can always find a paid CFP® planner to check what you own and / or make recommendations to your advantage.
You can also invest in commodities such as gold or silver . Like REITs, most large investment firms like Vanguard have some kind of precious metals fund that you can buy directly from your investment account. For example, Fidelity’s gold pool is FSAGX .
There are other creative possibilities as well. You can try peer-to-peer lending using a tool like Lending Club . I have about 1% of my portfolio invested in them, and the profitability is low, but others are more fortunate.
As with any investment, you want to know where you are going, which means checking the return on your alternative, its long-term effectiveness and commissions. As Forbes explains, 2% is usually the commission for those million dollar hedge funds. However, if you are buying an ETF or mutual fund, the commission shouldn’t be that high. Most mutual funds and ETFs have commissions of less than 1 percent.
In general, it is about keeping your portfolio balanced with something other than stocks and bonds. You want profits, and that may mean more risk, but that’s the beauty of a balanced portfolio: when one area fails, another backs you up.
Illustration by Sam Wooley.