Alternative investments are simply investment products designed to differ from stocks, bonds, and cash. Understanding the benefits of alternative investments and how they can contribute to a well-diversified portfolio is crucial in today's ever-changing financial landscape. From real estate to hedge funds, these unique options offer opportunities to enhance returns and reduce risk
An Evolved Asset Class
Alternative investments have come a long way, transitioning from a niche offering to a valuable tool for diversifying portfolios. They were developed decades ago and have long been used by institutional and high-net-worth investors to diversify existing portfolio holdings. Today, alternative investments and alternative strategies are accessible to a broader range of investors, offering opportunities to manage risks, achieve higher returns, and increase portfolio stability.
Understanding Correlation and Diversification
Correlation is the relationship of one asset class to another. Given a specific set of economic or market conditions, an asset class may move up or down in value. Correlation plays a crucial role in constructing a well-balanced portfolio.
The classic correlation relationship is that of stocks and bonds. Because stocks are generally riskier assets than bonds, when economic conditions are positive, investors tend to move investments to equities to reap the potential benefits. When economic conditions look more difficult, investors may shift their allocations to bonds, which have less risk.
This usually results in stocks and bonds having low correlations with each other. When one is experiencing positive performance, the other may decline in value. Diversifying a portfolio is the process of determining an asset allocation that spreads assets over asset classes with low or no (called “negative”) correlation to each other.
This lowers the volatility of the portfolio and helps protect against downturns. This is the theory behind the 60/40 portfolio, and for decades it worked well.
The problem has been that over the last several years, stocks and bonds have become more correlated to each other, making creating a well-diversified portfolio more challenging.
Alternatives May Offer More Diversification Benefits
Traditional investments like stocks and bonds are accessible through the public markets. While holding them long-term is often an investment strategy, it isn’t required. These assets are traded on public exchanges or markets and are considered liquid.
Alternatives generally are not publicly traded. This means these assets have limited liquidity or are illiquid. But because they don’t trade on public exchanges, they have low correlations to stocks and bonds. This is one reason investors use them to help diversify traditional portfolios. They may also help achieve other portfolio goals.
Types of Alternative Assets
There are many different types of alternative investments. Some of the most common types include:
Private equity: These are ownership investments made in a company that is not publicly listed. These investments attempt to capitalize on rapid growth or restructuring and also may create more value by playing an active role in streamlining operations or providing other expertise. While it can offer high returns, private equity is also associated with higher risk and illiquidity. Expertise in the specific industry is often crucial.
Private debt: These are loans made to private companies. These are bi-lateral transactions between the company and the investor and are governed by specific covenants on the deal to allow the investor and company interests to remain aligned. They provide capital to private companies that cannot access the capital markets in order to fund operations or grow. While private debt can provide steady income through interest payments, the risk of default is higher, especially if the company struggles.
Hedge funds: These are pooled investment funds that employ various strategies to earn returns for their investors. Common strategies include long/short equity (buying undervalued stocks and shorting overvalued ones), using derivatives, arbitrage, and more. Hedge funds can offer diversification and potential for high returns but are often illiquid, complex, and can be costly due to high management fees.
Real assets: Real assets encompass a wide range of physical investments. These include real estate, infrastructure, natural resources, agricultural land, and commodities.
The Goal of Alternative Investing
In general, alternatives may help to lower portfolio volatility by adding diversification to an asset allocation. Specific goals will often be related to the type of strategy or asset chosen. For example, a private equity investment may provide the potential for higher returns, while a private credit strategy may be chosen for enhanced income potential.
For an investor, alternatives may offer the ability to create a portfolio that is more customizable to their goals. For younger investors, retiring early or creating a “work-optional” financial plan may mean building more options into a financial plan. For retirees, alternatives may provide more stable income.
These strategies are often illiquid, so it’s important to understand how much of the portfolio is dedicated to long-term investing and how much may need to be accessible for use. Having a clear understanding of the illiquid nature of these strategies is critical.
The Bottom Line: Alternative Investments & Your Financial Goals
Alternative investments have become much more mainstream in recent years, opening new opportunities for investors to diversify their portfolios. With increased accessibility, these assets can play a crucial role in creating a portfolio strategy that aligns with your financial goals. Explore the world of alternative assets to protect your wealth, unlock greater investment potential, and achieve your financial future.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
This content not reviewed by FINRA
Alchemist Wealth, LLC is registered as an Investment Adviser with the State of Ohio and only provides advisory services in states where registered or otherwise exempt from registration. All information provided herein is for educational and informational purposes only and should not be viewed as investment advice. Any links to third party information or data are believed to contain accurate information at the time of publishing.