There are more to investing than just bonds and stocks.

Investors who want to reduce their volatility exposure and generate additional returns than holding bonds and stocks may be interested in alternative investments. Alternative investments are a great option for diversifying your portfolio if you’re the right investor.

The Key Takeaways

Alternative investments include a variety of assets not included in the core asset classes of cash, stocks and bonds. Alternative investments are used by investors to diversify their portfolios or capitalize on market conditions, special interest, or unique knowledge. Alternative investments may be subject to different taxation depending on their specific assets. Buyers should be aware of hidden fees and legal hurdles.

What is an Alternative Investment?

Understanding two concepts related to “asset classes”, and “asset allocation” is necessary in order to appreciate the definition of alternative assets. An asset class refers to a specific type of asset. A handful of core asset classes can be added to an investor’s investment portfolio. These are:

  • Cash and cash equivalents
  • Stocks
  • Bonds1

An alternative investment or alternative asset is, in its broadest meaning, any asset that doesn’t fall within one of the three categories. Asset allocation is the way that you divide your investments between different types of assets.

Alternative Investments: Examples

You might also consider these alternative investments in the real world:

  • Real estate includes directly owned property, reale limited partnerships, reale development corporations and reale estate trusts ( REITs).
  • Master limited partnerships can operate and own everything, from oil pipelines to the parks.
  • Tax lien certificates
  • Privately held businesses may have stock or membership units
  • Commodities includes precious metals like gold, silver and platinum as well as crude oil (natural gas), ethanol, corn soybeans, wheat or cocoa.
  • Farmland
  • Timberland
  • Mineral rights
  • Intellectual property includes copyrights and patents as well as trademarks
  • Privately underwritten mortgages
  • Leasing equipment
  • Structured settlements
  • Art and collectibles
  • Private equity
  • Wine
  • Numismatic coins
  • Venture capital
  • Peer-to-peer lending
  • Hedge funds
  • Annuities

Alternative Investments: The Pros and Cons

It is wise to understand the potential drawbacks and benefits of alternative investments before making any other investments.

Benefits Drawbacks
Possibility to have tax-advantaged cash flows or sheltered cash flows Possibility for negative tax consequences
Opportunities can be found in less-efficient markets Transparency is a problem that can lead to significant hidden risks
Emotional and intellectual satisfaction Complex investments

Why investors seek out alternative investments

Alternative investments are something that portfolio managers and investors may consider.

Tax treatment

Sometimes, money from an alternative investment may be subject to a far better tax treatment than money from a traditional investment. If an investor or client has substantial tax loss carryforwards or tax credits that could be applied to a specific type of activity, or source of income.

Favorable conditions

Other times, the asset class might appear to be significantly less expensive than other investment options due to market conditions or other factors. In the wake of the Great Recession, wealthy investors bought condos at a fraction of their expected market value in Miami.

Unique Skills or Knowledge

Sometimes the advisors or investor have deep knowledge in a particular area that can make alternative investments more sensible. An example: If an oil and gas entrepreneur has the patience and resources to capitalize on a major oil glut, this knowledge and experience could pay handsomely.

Intellectual Interest

Other situations might require that an alternative investment or asset class be more attractive to investors than other types of investments. Venture capital is a popular investment option for successful investors. They enjoy the process of funding and owning startups and other relatively new businesses.

Control

Some investors don’t like investing in stocks and bonds. They prefer to own their mortgages and own real estate properties that they’ve renovated and acquired. They find it logical. They believe they are better able to understand the potential gains or losses than owning common stock that is publicly traded.

Collaboration

Some investors acquire music copyright catalogs at auction or in negotiated transactions. They understand how to license and administer those rights to interested parties.

Collections

There are also the “gold bugs”, who are bullish about gold and collect it in bar and coin form.

3 Tips for Long-Term Investing

You must know how much money to invest before you can make long-term investments. This means putting your finances in order. Taylor Schulte, a San Diego-based certified fiscal planner ( CFP) is the host of the Stay Wealthy podcast.

Take stock of all your assets and debts. Then, create a debt management strategy. Also, understand how much you will need to stock an emergency account. These financial tasks will help you to be able put money into long-term investments without having to withdraw any more. You should not withdraw funds from your long-term investments too early. This can lead to you selling at a loss, and could have tax consequences.

Every investor has different goals, such as retirement, college tuition, or building a down payment on a house. Whatever your goal, understanding your time horizon is key to long-term investing. This means knowing how long you have before you need the money. Long-term investing is generally defined as five years or longer, although there is no definitive definition. Understanding when you will need the funds that you are investing in will help you make better decisions about which investments you should choose and how much risk to take.

CFP Derenda King from Urban Wealth Management, El Segundo, Calif. suggests that someone who invests in college funds for a child 18 years old can take on more risk if they are able to do so. She says that they may be able invest more aggressively as their portfolio has more time for market volatility to subside.

After you have established your goals and time horizon, pick an investment strategy and stick to it. You might find it helpful to divide your time into smaller segments to help you choose asset allocation.

President and CEO of Francis Financial, New York City, Stacy Francis divides long-term investment into three buckets based on your target date: five to fifteen years away, 15-30 years away, and more than thirty years away. Francis recommends that the portfolio with the shortest timeframe be the one most conservatively invested. It should contain between 50% and 60% stocks, the remainder in bonds. The most aggressive portfolio could include stocks up to 85%- 90%.

Francis states, “It’s great that you have guidelines.” Francis says, “But realistically you have to do your best.” It is especially important to select a portfolio that you are comfortable with so you can stick to your strategy no matter what.

Francis says that a market decline can cause a lot anxiety and fear as your portfolio tanks. “But selling during a market downturn and locking in losses are the worst things you can do.

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