It’s pretty easy to get started investing. Once you dig into it, though, a lot of questions come up that complicate the process. You might have come across the phrase alternative investments, and if you’re new to investing, you probably have no idea what it means. Here’s a quick breakdown for the average personal investor.
What is an “Alternative Investment”?
Let’s say you’re invested long-term for your retirement. You have a superannuation account 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 for yourself.
As your net worth grows, though, it’s time to take your portfolio up a notch. You want to diversify it even more, because, over time, a diverse portfolio is a lucrative one. A properly diversified portfolio includes different types of stocks and bonds — international stocks, for example — and it also includes something called alternatives.
Alternatives can be useful in a portfolio to provide some balance. Often (but not always) when stocks and bonds drop, assets like commodities and real estate may rise. “Alternative asset” is a broad term that includes assets that are not stocks, bonds, or cash. Examples would be commodities (like gold), private equity and hedge funds, collectibles, and real estate. Often they are more complex assets that are more difficult to value and harder to turn into cash.
So technically, your old collection of Beanie Babies counts as an alternative. However, to invest in alternatives properly, it helps to understand how they work in a little more detail.
Why You Should (and Shouldn’t) Invest in Alternatives
If you’re just starting out with investing and playing catch up with your retirement, you might not be that interested in alternatives. You just need to focus on saving and building a simple set-and-forget portfolio. When your net worth starts growing, though, it might be time to squeeze alternatives into your portfolio. Financial Samurai’s Sam Dogen explains why:
With a larger net worth, you invest some of your savings into Alternative asset classes by age 35. Alternative asset classes may include: private equity, venture capital / angel investing, or starting your own company. You’ve got stocks, bonds, and real estate down pat. With free liquidity, you dable into the unknown because you never want to look back and say, “what if.”
After the age of 40, you’re looking for a more balanced mix in your net worth. As a result, you purposefully invest less in stocks and more into bonds and alternative investments. Your real estate equity also holds steady, market willing.
This is important: Alternatives aren’t meant to replace your entire portfolio. They’re meant to enhance it. Some investors will invest strictly in alternatives, though, like hedge funds. Warren Buffett, considered to be the world’s greatest investor, reminds us that they’re not a great deal, according to CNBC:
During the financial crisis, Buffett bet the asset management company Protege Partners LLC $1 million that the S&P 500 will outperform a portfolio of hedge funds over the 10 years through 2017. Buffett said Saturday the index fund is beating the hedge funds by nearly 44 percentage points over 8 years.
When the stock market drops considerably, though, people tend to freak out and, against better judgement and statistics, sell their stock and turn to alternatives like real estate, gold or other commodities. While those investments can be fruitful, depending on the time-frame you’re looking at, they’re also volatile and probably not smart investments for your retirement.
For example, gold prices soared during the ’80s and the Great Recession, but the Motley Fool’s John Maxfield explains why this doesn’t paint a full picture:
But the problem in both of these cases is that the price of gold soon dropped as quickly as it had formerly climbed.
It was less than $600 an ounce by 1985. And since peaking in 2011, gold has lost more than a third of its value.
To benefit from these fluctuations, then, an investor would have to time the market — something we know to be dangerous, if not impossible, for the average investor to do successfully.
In other words, alternatives are great for hedging and balancing your portfolio when the market drops, but that’s it. You should have them in your portfolio, but again: They’re not meant to replace your portfolio.
Calculate How Much of Your Portfolio Should Be in Alternatives
Here’s a basic rule of thumb for how to calculate your asset allocation, that is, the amount of your money that should be invested in stocks versus bonds:
110 – your age = the percentage of your portfolio that should be stocks
That means if you’re 30, you’d put 80 per cent of your portfolio in stocks (110 – 30 = 80) and the remaining 20 per cent in lower-risk bonds. This is a good starting point, but it doesn’t account for alternatives. And most basic asset allocation calculators only include stocks, bonds and cash.
If you’re looking for a simpler solution, here’s what we suggest:
In most cases, alternatives should not be 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 to own (vs. 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 shifts to bonds, but you may also want to invest in more alternatives to balance things out. - lifehacker
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