Alternative investments are financial assets not falling into conventional asset categories, such as stocks, bonds, and cash. They include private equity, hedge funds, real estate, commodities, and cryptocurrencies.
These offer investors the potential for diversification, higher returns, and access to unique asset classes.
However, evaluating and selecting alternative investments can be a challenging task. There are many things to consider, such as the level of risk, liquidity, fees, and historical performance.
Here is a step-by-step process to help you navigate the world of alternative investments and make smarter investment decisions.
Step 1: Assess Your Risk Tolerance, Investment Objectives, and Time Horizon
When exploring alternative investments, keeping up with the latest alternative investment news is crucial.
But before making choices, you need to understand these factors clearly.
You need to weigh how much risk you are willing and able to take with your money. It depends on your age, income, net worth, personality, and financial goals. The higher your risk tolerance, the more aggressive your portfolio can be.
You also need to decide what you want to achieve with your money and how long you plan to invest your money for that. The longer your time horizon, the more time you have to recover from market fluctuations and benefit from compound interest.
You can use online tools such as risk profile questionnaires or financial calculators to determine these parameters based on your situation. You can also consult a financial planner or advisor for professional guidance.
Once you have a clear picture, you can use them as the criterion to filter and select alternative investments that match your profile.
Step 2: Research Different Types of Alternative Investments and Their Characteristics
Alternative investments can vary widely in terms of their structure, strategy, fees, performance, and regulation
Here are some common types of alternative investments and their characteristics:
Private Equity
Private equity funds are pooled investment vehicles that aim to acquire controlling stakes in private and public companies. They take an active role in managing their portfolio companies, providing intellectual and financial capital.
A private equity fund buys part of a company to make it better and help it grow faster. The fund makes money when it sells its part of the company, usually when it goes public or sells to another company.
Private equity funds typically have high minimum investments (usually $1 million or more), long lock-up periods (usually 5 to 10 years), high fees (usually 2% management fee plus 20% performance fee), and low liquidity.
They tend to have high returns (usually 10% to 20% annualized) and high risk (due to leverage, operational challenges, and market conditions).
Venture Capital
Venture capital investment also has the same characteristics. The only difference is that VCs invest in early-stage startups with high growth potential. Again, they provide capital, mentorship, and network access to their portfolio companies.
They also provide higher average returns (usually 15% to 25% annualized) but at very high risk (due to uncertainty and competition).
Hedge Funds
Hedge funds are another pooled investment vehicle that tries to generate high returns using various strategies and instruments, such as short selling, leverage, derivatives, arbitrage, and hedging.
They can invest in any asset class or market, often exploiting market inefficiencies and anomalies. Hedge funds typically have short to medium lock-up periods (usually 1 to 5 years) and medium liquidity.
Commodities
Commodities are physical goods that are traded on exchanges or over-the-counter markets.
They can be invested directly or indirectly through futures and options contracts or by buying shares of commodity producers or funds that track commodity indexes.
Commodities have low minimum investments, no lock-up periods, low fees, and high liquidity. They have moderate returns and moderate risk.
Other alternative investments include real estate, bitcoin, collectibles, and more. Each type of alternative investment has unique characteristics that may appeal to different investors depending on their preferences and goals.
Step 3: Evaluate the Quality and Reputation of the Alternative Investment Manager or Platform
Alternative investment managers or platforms are the entities that offer, manage, and operate alternative investments.
They can be specialized professionals or firms that have expertise and access to niche markets. They can also be online platforms that connect investors with alternative investment opportunities. They charge fees for their services and share in the profits or losses of alternative investments.
Before investing with them, you should assess the alternative investment manager or platform’s track record, credentials, transparency, and alignment of interests.
You can use various sources of information to evaluate alternative investment managers or platforms, such as their websites, brochures, prospectuses, financial statements, audits, ratings, reviews, and testimonials.
You can also consult industry reports, newsletters, podcasts, and websites that provide data and insights on alternative investments.
Step 4: Compare and Contrast Different Alternative Investment Opportunities and Select the Ones That Match Your Criteria
Once you have decided on your preferred instruments and identified potential alternative investment managers or platforms that meet your standards, you must do some matchmaking.
Some of the factors that you should consider when evaluating alternative investments are:
- Expected return and risk profile
- Historical performance and track record
- Fees and charges
- Liquidity and exit options
- Tax implications
- Legal and regulatory issues
- Manager reputation and expertise
You should also diversify your portfolio across different types of alternative investments. It reduces your overall risk and volatility by spreading your investments across different sources of return and risk.
The Bottom Line
Following this step-by-step process, you can choose the right alternative investment for your portfolio and enjoy diversification benefits, higher returns, and lower correlation with the stock market.
However, choosing the right alternative investment is not enough. You must also monitor your alternative investments regularly and adjust your portfolio accordingly.
Alternative investments can be complex, making them difficult to understand. It’s always recommended to seek professional advice from financial planners or advisors.