Beyond Stocks and Bonds: The Pros and Cons of Alternative Investments

Adding alternative investments to your portfolio could bring diversification, higher returns, and hedging potential. Gumbariya/Shutterstock

Most investors agree that diversifying your portfolio is key to mitigating risk, while capturing returns. But there’s more to the world of investing than the standard mix of stocks, bonds, and cash.

And that’s where alternative investments step in. These assets can include real estate, precious metals, and collectibles. And they can offer more than just diversification.

Real estate and gold, for example, have historically hedged well against inflation. And private equity firms can deliver superb returns when the companies they invest in succeed.

But alternative investments may also have disadvantages, such as illiquidity. You may be sitting on a small fortune worth of antiques, but it could take time and effort to get your items appraised for their fair market value and find the buyers willing to pay your price. Plus, investments such as hedge funds and private equity are generally reserved for high-net-worth investors.

But as technology emerges, more and more retail investors may find an easier route to alternative investments. That makes it immensely important to weigh the potential benefits and risks of alternative investments before deciding if they are a fit in your portfolio.

So let’s take a closer look at the pros and cons of alternative investments.

Mitigating Volatility

Alternative investments generally have a low correlation to the stock market. This means they don’t usually move in the same direction.

So diversifying your portfolio with alternative investments could help you mitigate volatility and capture returns even in a down market.

For instance, many investors refer to gold as a “safe haven” investment that can perform well when markets decline. But has it stood the test of time?

During the recession of 1980–82, the benchmark S&P 500 Index dropped by 27 percent while gold spiked by 46 percent, according to an analysis by RJOFutures, a futures brokerage. And during the dot.com crash of 2000–02, gold picked up 12 percent while the S&P 500 plunged 49 percent.

But like everything in investing, nothing is certain. Alternative investments don’t always deviate in correlation from the stock market.

Gold and the S&P 500 have seen strong returns in 2024, with both looking back at rallies as we close out the year.

Year to date as of this writing, the price of gold is up about 30.56 percent and the S&P 500 has risen by around 32.06 percent. Some analysts project gold is in for a slump in anticipation of the Federal Reserve taking a cautious approach to interest-rate decisions in December.

The price of gold historically has had an inverse relationship to interest rates. But other factors such as geopolitical shifts can also greatly impact the price of gold.

So it’s crucial to carefully analyze gold as an investment. But you don’t need to buy and store physical gold to benefit from its value. You can buy shares of exchange-traded funds (ETFs) that track the price of gold or purchase gold futures contracts.

Inflation Hedge

Some alternative investments such as real estate have been known to rise along with inflation.

One of the simplest ways for retail investors to benefit from property values without physically owning any is by investing in real-estate investment trusts (REITs).

A REIT is a company that owns or operates income-generating real estate such as apartment buildings, office space, and hotels. You can invest in a REIT through various brokerage accounts much in the way you’d buy shares of a stock.

And during high inflationary periods, specific REITs have outperformed traditional asset classes such as stocks. Some of these include industrial and logistical REITs that invest in warehouses, distribution centers, and facilities that make food and essential products. These properties are generally tied to long-term leases. Plus, tenants pay for maintenance, insurance, and real estate taxes. This could create steady cash flow for the REIT and its investors. In addition, REITs linked to housing can also provide inflation protection as rents typically rise when prices and interest rates increase.

REITs’ returns since the 1970s have outperformed the stock market in 56 percent of the 12-month periods indicating high inflation, and more than 80 percent of the 12-month periods where high inflation was continuing to rise, according to an analysis by Nareit.

But remember, inflation doesn’t only account for the costs of basic goods. It also represents the rise in the costs of the materials they’re made of.

This is one of the reasons why many commodities tend to rise along with inflation as well. Commodities are the raw materials that go into consumer goods. Think grain, sugar, and meat. But it also includes precious metals such as gold, silver, and platinum, and energy sources like oil and natural gas.

So have commodities performed well in times of heightened inflation? A one percentage-point surprise increase in U.S. inflation on average has caused a real inflation-adjusted return of seven percentage points for commodities and a three percentage-point decline in stocks, according to an analysis by Goldman Sachs.

But as with gold, you don’t need to physically hold commodities to benefit from their growth. You can invest in ETFs that track the prices of specific commodities or the wider market.

Still, commodity prices can be highly volatile. For instance, a slight shift in supply and demand triggered by geopolitical turmoil can severely affect the price of commodities.

Higher Returns

While future performance is never guaranteed, some alternative investments have outperformed broader market indices.

For instance, private equity outperformed the Russell 2000, the S&P 500, and venture capital through the 20-year period ended June 2020. Private equity returned 10.48 percent and the S&P 500 pulled 5.91 percent in that time frame.

Private equity companies raise funds from wealthy investors and organizations to buy and manage companies before selling them for a profit. Venture capital firms, a subset of private equity, focus on new companies or start-ups. But it’s important to note that many start-ups fail and even companies that experts deemed to have potential don’t go far in the long run.

With that said, private equity and venture capital can be difficult to get into.

So let’s take a look at the potential disadvantages of alternative investments.

Illiquidity

If you need cash, you can easily sell your stock and ETF shares. This isn’t the case with many alternative investments.

It can take years to see a return on private equity. And if you own physical property such as a home or other piece of real estate, you’d need to go through an often lengthy process of selling it.

So even if you’re venturing into alternative investments, it’s important to prioritize your emergency fund and have a dedicated space in your portfolio for liquid assets like cash, stocks, and mutual funds.

Access

Alternative investments such as private equity and venture capital are limited to accredited investors. These are high-net-worth individuals who need to meet certain criteria. So the typical retail investor may not be able to access some alternative investments.

Nonetheless, there are a number of crowdfunding platforms out there that allow retail investors to invest in new companies online.

High Risk

There is risk involved with any investment. But investing in alts may require you to take a closer look under the hood.

With traditional assets, you can look at easily accessible and publicly available data like earnings reports and fund prospectuses. That may not be the case with alternative investments.

Alternative investments may engage in strategies that aren’t always clear, and their structures may not be too transparent.

And keep in mind that alternative investments typically involve higher risk and higher fees than their traditional counterparts. So, going into these without the right knowledge or risk tolerance can have severe consequences.

You also need to take into account other risks. If you’re renting out property, for example, you may need to engage in routine maintenance and other unexpected tasks.

Are Alternative Investments Right for Me?

Adding alternative investments to your portfolio could bring diversification, higher returns, and hedging potential. But these could come with an uncertain degree of risk. You need to consider factors such as ease of access, liquidity, and your own risk tolerance.

It’s essential to conduct your due diligence when considering alternative investments, and never invest more than you’re willing to lose.

The Epoch Times copyright © 2024. The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.