U.S. markets have some characteristics Goldilocks might recognize: Stock prices are too high but bond yields still are too low. That’s got some investors looking for alternatives.
For many, that quest will inevitably lead to alternative investments. This broad-reaching category includes currencies, commodities, real estate, private equity and even art or collectibles — basically anything outside the stock and bond markets.
Are alternative investments just right for your portfolio? Not necessarily. Here’s what you need to know before investing.
Alternative assets: A different world
Venturing beyond traditional asset classes takes effort — and for good reason. While Goldilocks had inconsequential options of porridges, chairs and beds to choose from, alternative investments comprise some much riskier choices. “Alts,” as they’re known, typically have higher fees, risks and taxes — and often have less transparency (pricing) and liquidity (how easy it is to buy or sell the assets).
Most alternative assets won’t be an option to buy through online-only brokers; they are available from money managers and wealth management firms. Alts have an air of exclusivity, thanks to minimum net-worth requirements and not-so-accessible channels for investing. (Feeling lost? See this guide on how to invest money.)
You may field a sales pitch from an investment advisor (or acquaintance) that touts the diversification benefits and potentially higher returns of alts. Since the financial crisis, these pitches have become more mainstream as investors seek ways to safeguard their portfolios from market swings — alternative investments typically don’t move in sync with stocks and bonds.
Alternative investments include assets you may already own, like real estate investment trust funds (or REITs) that are common in many retirement plans, along with those typically reserved for professional investors: commodities, currencies, futures, private equity and hedge funds. But that list is not exhaustive — and what’s fringe for you may be a commonplace investment for someone else.
What’s the catch?
A variety of studies tout two main selling points of alts: better diversification and returns. Adding alternative investments to a portfolio (up to 10% of total allocation each to hedge funds and private equity) increased performance and decreased risk in the 1990-2016 period when compared with a portfolio composed of just stocks and bonds, according to a report from the Wells Fargo Investment Institute.
But it’s important to note the potential downsides of these investments, too.
As niche products, alternative investments generally carry higher fees than traditional assets — and sometimes it’s hard to nail down exactly what those fees will be. In addition, you’ll need to research the tax implications for any potential investments and compare them with those for stocks and bonds, which can be held in tax-deferred accounts like a 401(k) or IRA.
Then there’s the issue of transparency. The opaque nature of many alternative assets can add to their allure, which may evaporate as soon as you lose money.
Key questions to ask before any purchase: Do you know what you’re buying? Are you buying from a reputable source who has done due diligence? The Securities and Exchange Commission and the Financial Industry Regulatory Authority have issued alerts to address some of these issues, but you’ll need to do your research, as well.
Finally, your experiences in the traditional world of investing may no longer apply, so be sure you know what’s at stake. How easy will it be to tap into your money when you need it? What information do you lack that someone on the other side of the trade has access to? In the stock market, a wide variety of data are readily available to all investors. That’s usually not the case with alternative investments.
How much is just right?
Many people won’t stray far from stocks and bonds over the course of their investing lifetime, but there is growing interest in alternative assets. Even as financial advisors look for new ways to diversify, a vast majority of these advisors are allocating no more than 10% of their clients’ portfolios to alternative investments, according to a study published in June by the Financial Planning Association, LongboardAsset Management, and the Journal of Financial Planning.
Figuring out the right mix of investments is a challenge for all investors. Whether alternative investments deserve a spot in your portfolio largely comes down to your appetite for risk. The merits of investing in the stock and bond markets are well-documented, but that’s not the case for all types of alts.
So make sure you understand what you’re investing in and its risks — and dedicate no more than a small fraction of your total assets at the beginning.
What’s an alternative to the alternatives?
Not ready to take the plunge with alts? That’s OK, too. There may be options hidden in mainstream investments that allow you to mix up your portfolio.
One place to look is the U.S. stock market, with thousands of options among individual stocks, mutual funds and exchange-traded funds. You often can achieve the diversification of alternative investments without leaving the well-worn path of the stock market. (Read more about the stock market.)
Take gold, for instance. In 2010 and 2011, investors flocked to the commodity as a perceived safe haven from political and economic uncertainty. But there was another way to catch gold rush fever: investing in an exchange-traded fund composed of gold mining companies. This is just one example of a way to tap the world of alternative investments in the equity market. (Intrigued by ETFs? Check out this analysis of the best brokers for ETF investing.)
Anna-Louise Jackson is a staff writer at NerdWallet, a personal finance website. Email: firstname.lastname@example.org. Twitter: @aljax7.