A few days ago the stock market again hit a new all-time high. But instead of feeling unalloyed glee, many investors seem to be struggling with mixed emotions. They are, of course, thrilled at their gains. But at the same time, they are hesitant to invest further into a market that has already gained so much. As a result, folks have been asking, “Isn’t there anything else I can buy?” Oftentimes, this leads to questions about “alternative investments.” Below is an introduction to this topic along with my recommendations.
What are “alternative investments”?
In simple terms, an “alternative” is any investment that is not a stock or a bond, the two pillars of a traditional investment portfolio. Alternatives include commodities (such as corn, livestock, crude oil and precious metals), real estate, stock options, futures contracts, and other esoteric kinds of investments.
In addition, the investment industry uses the term “alternative” to refer to any investment structure which differs from a traditional mutual fund or exchange-traded fund (ETF). The most well known are private equity, venture capital and hedge funds, all of which are generally structured as private partnerships.
So the world of alternatives is broad and extremely diverse.
What benefits do alternatives offer?
There are two reasons why you might consider alternative investments:
The first is that you might expect better returns. If you’re worried that the stock market is due for a breather after rising for nearly ten years, then you might look to alternatives.
The second reason is diversification. When you look to add alternatives to your investment mix, you’re looking for things that will zig when the rest of your portfolio zags. In mathematical terms, you’re looking for things with low correlations to stocks.
Do I need alternatives?
In general, diversification is a good thing. But before you jump headlong into alternatives, take some time to evaluate what you already have. Though you may not have thought about it in these terms, it’s possible that you already have alternative exposure of one kind or another. If you have a rental property or if you own a business or if your job provides a pension, then you already have assets that are not tightly correlated to the stock market. They may provide all the diversification you need.
What if I want more diversification? Should I invest in alternatives?
If, after evaluating your personal balance sheet, you decide you need more diversification, should you invest in alternatives? Unfortunately, the track records of most alternatives funds are not great. In a 2015 study, The Wall Street Journal found that the single best form of diversification during a stock market downturn — when you need diversification most — came not from alternatives but from the simplest of traditional investments: bonds.
Long-term data confirm this finding. Over the past ten years, bonds have provided far better portfolio diversification than virtually every other type of investment, including alternatives like commodities, private equity and real estate. Bonds have actually demonstrated negative correlations to stocks, meaning that when stocks have gone down, bonds have gone up, and vice versa. While there is no guarantee that bonds will always offer this same benefit, there are logical reasons why they usually move inversely to stocks. That is why I believe strongly that a simple portfolio of stocks and bonds (and cash) is the most effective way to achieve diversification.
Does this data mean I should never invest in alternatives?
The world of alternative investments is vast and diverse, and I want to make an important distinction: The sorts of alternatives that I would avoid are the alternatives funds that are marketed to the public. As I have noted before, there are definitely hedge funds and other alternatives that have delivered off-the-charts performance, but those funds are rarely available to the general public.
But that doesn’t mean you should avoid alternatives altogether; I’m just advising against the retail, mass-market variety. The best opportunities, in my opinion, will present themselves individually. For example, it might be a startup company in your industry or a real estate rental unit in your community. These are the sorts of things that may very well deliver outsized potential. But you’ll need to evaluate each prospective investment on its own merits. In addition to estimating its return potential, you’ll want to consider the investment’s liquidity, costs, tax impact, and the track record of the individuals who will be managing it. Most importantly, ask yourself whether the investment’s strategy passes the common sense test. The investing genius Peter Lynch once said that he would never invest in anything that couldn’t be illustrated with a crayon. That is an especially important principle when evaluating alternatives.