What are alternative investments – and are they for you?
The stock markets are bouncing off all-time highs in the face of an economy that is walking a tightrope. The Federal Reserve has been providing the net, calming nervous investors, but even a safety net is not 100% foolproof. So, what is an investor supposed to do? Sit out of the market altogether and watch it go ever higher? Institutional investors, like pensions and college endowments, have long used alternative investments to hedge their bets. So, what exactly are alternative investments?
Traditional investments in stocks, bonds, or cash have what is called a “normal” or symmetrical range of returns. Using historical data, we can plot this range of returns. It is shaped like a bell (a bell curve) with as many returns falling above the mean as below. Alternative investments have an asymmetrical curve, meaning more returns fall on the positive side of the mean then the negative side of the mean.
Wow, so why doesn’t everyone invest in an alternative investment that goes up more than it goes down? For one, these types of investments can be costly to invest in and, two, their overall return may be lower than traditional investments.
So, alternatives mixed with traditional investments offer the best of both worlds for the average investor. A Blackrock study utilizing a 20-year investment period showed that adding just a 20% allocation to alternatives in your investment portfolio meaningfully reduces your risk while simultaneously increasing return. There have been other studies with varying allocations of alternatives with traditional investments that show similar results.
Alternative investments come in many different flavors. As we mentioned before they are a great complement to your existing portfolio, so it is important to really understand the types of investments you own and their risk characteristics. Combining the wrong alternative investments into your portfolio may cause more
damage than they seek to cure. Options trading is a leading alternative investment often used to increase returns while limiting or reducing your risk. For example, you may have too much of one stock in your portfolio, but do not want to sell it. You can use options to protect against a decline in the stock. Just like any insurance policy, there is a cost for the protection, but it may be worth it to you.
There are also mutual funds, exchange-traded funds (ETF’s), and hedge funds that utilize option strategies and shorting stocks to profit from a decline. Others create strategies that appreciate only to a certain level or “cap” when the market rises, but then only decline to a certain level or “floor” when markets decline. These types of investments create a defined outcome because you know the most you can make and/or lose.
New types of alternative investments are being created, it seems, every week. The search for the perfect investment that goes up but rarely down is the pot of gold at the end of the rainbow… elusive. But alternative investments have earned their place in most portfolios. Continued innovation should make alternatives less costly,more predictable, and more widely available to the average investor.