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Alternative investments: What they are and how they work

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When it comes to investing, many people typically consider securities such as stocks and bonds. These traditional investments, along with cash, form the majority of retirement portfolios for most investors. However, there is another category of investments known as alternative investments that has experienced significant growth in recent years.

Now, let’s delve into what you need to know about alternative investments and how they can bring diversity to your portfolio.

What are alternative investments and how do they work?

Alternative investments are a departure from the conventional realms of stocks, bonds, and cash. They encompass a diverse array of assets, such as real estate, commodities, private equity, and hedge funds. These non-traditional investments exhibit certain distinctive traits:

  • Low liquidity – Selling or converting to cash may not be as straightforward or effortless.
  • Higher fees – Expense ratios for these investments typically exceed those of traditional investments.
  • Complex structure – Certain alternative investments can be intricate and restricted to accredited investors.
  • Less regulation – Alternative investments are held to the same regulatory standards as conventional investment options, like mutual funds or ETFs.
  • Potentially low correlation – Alternative investments offer an enticing opportunity to diversify portfolios as they often exhibit little to no correlation with traditional assets.

Types of alternative investments

Real estate

Real estate, as one of the largest asset classes, offers investors the opportunity to profit from physical properties or securities like real estate investment trusts (REITs). By investing in real estate, individuals can generate income through rental payments and potentially benefit from capital gains if the property increases in value.

Individual investors have the opportunity to invest in real estate at relatively low costs through options such as REITs or real estate-focused ETFs. Additionally, owning a home or rental property can serve as an investment strategy.

Commodities

Commodities represent an alternative investment category encompassing valuable natural resources like oil, natural gas, gold, and diverse agricultural products. The prices of commodities typically react to shifts in supply and demand for the respective resources.

Investors have multiple avenues to tap into the world of commodities. While numerous ETFs allow them to monitor the performance of various commodities, they can also leverage derivatives or directly hold commodities to capitalize on price fluctuations.

Private equity

Private equity entails investing capital in privately held companies or start-ups, commonly referred to as venture capital investments. While it may seem akin to investing in publicly traded stocks, private equity deals exclusively with non-publicly traded enterprises. A private equity fund often collaborates closely with the companies it invests in, playing an active role in strategy formulation and influencing decisions regarding capital allocation.

Private equity funds are generally exclusive to institutional investors and high net worth individuals. While the fees associated with these funds can be significant, certain ones have the potential to outperform conventional stock market indexes by a considerable margin.

Hedge funds

Hedge funds employ a combination of traditional and alternative investments, utilizing strategies like shorting or derivatives to manage their funds. Fees charged by hedge funds can vary, but they have popularized the “2 and 20” fee structure, entailing a 2 percent annual management fee and 20 percent of the fund’s profits.

These investment vehicles are exclusively accessible to institutional investors and high net worth individuals.

Collectibles

Collectibles encompass a diverse array of alternative assets, spanning a wide range of items such as:

  • Art
  • Wine
  • Trading cards
  • Vintage cars
  • Stamps
  • Coins

Collectible investors aim to capitalize on future price appreciation when they sell their items. Unlike traditional investments that generate income through dividends or interest, collectibles rely solely on their potential for profit.

Bottom line

Incorporating alternative investments into your portfolio can provide diversification, especially when these assets exhibit a low correlation with traditional investments such as stocks and bonds. This lack of correlation means they often move in opposite directions, offering a potential hedge against market fluctuations. However, it’s important to note that alternative investments typically have limited liquidity and may involve higher fees.

Therefore, it is advisable to allocate a proportionate, rather than a significant, portion of your portfolio to these assets.

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