Successful investment strategies are built on diversification, as different assets respond differently to the same market trends. For example, when stocks rise, bond prices tend to fall and when bond prices rise, stock prices typically fall. However, more experienced investors may want to look outside conventional investments like stocks and bonds to alternative investments for opportunities to minimize risk and maximize growth.
Alternative investments do not fit into the conventional equity, income, and cash categories. These investments include, but are not limited to, private equity, private lending, hedge funds, commodities, real estate, and crypto. Although each alternative investment has unique characteristics and regulatory/legal considerations, they are all investments that well-informed investors can use to diversify their portfolios and manage risk.
Key Takeaways
- Diversification across asset classes, industries, and geographic locations helps mitigate risk and maximize returns.
- An alternative investment is a financial asset that does not fit into the conventional equity/income/cash categories.
- Account for each alternative investment’s regulatory requirements and unique risks before adding them to your portfolio.
- Alternative investments are often less liquid than traditional investments.
Private Equity
Private equity investing happens when investors purchase privately held companies. Investors do so by investing with a private equity firm that pools resources to acquire, manage, and grow businesses before selling the companies to another firm or through a private offering.
How to invest: Private equity funds are not registered with the SEC and are not subject to the same regulatory requirements as listed investments, so opportunities to invest in private equity are typically only available to accredited investors. These investors have an annual earned income of at least $200,000 or a net worth of $1 million and hold certifications for financial professionals.
Even if you qualify, you will need connections or information from a financial advisor to determine available private equity opportunities. Once you’ve selected your private equity firm and they’ve vetted you for accredited investor status, you can make your investment with the firm directly.
Best suited for: Investors in private equities must be accredited investors seeking high return potential. Private equity investors must have a suitable risk tolerance. The amount of initial capital required to participate in these investments means that the pendulum swing between loss and returns is very high.
Warning
Private equity investing is also highly illiquid, so only investors with a long time horizon should consider investing.
Risks: Private equity funds are illiquid and have higher fees than other investments. While there is potential for significant returns, there are no guarantees that the private equity firm will turn a profit on the company when it’s time to sell. Historically, well-picked private equity investments have returns that compensate for the liquidity issues and fees.
Portfolio fit: Investors wanting to diversify away from only public markets may find private equity a suitable investment.
Private Lending (Also Called Peer-to-Peer Lending)
Private lending, also known as peer-to-peer lending, is any lending that occurs outside of institutions like banks or any open market. Private or public companies or individuals borrow money from investors to scale their businesses. The investors make money through principal repayment and interest payments over the life of the loan.
How to invest: Private lenders can invest in a few ways. One of the easiest methods for private lending is to find a reputable P2P lending platform. These websites act as a matchmaker between lenders and borrowers. Investors can choose to invest in one loan or to contribute to many loans. Private lenders may also connect directly with a borrower and, with the help of a professional, draft the repayment contract.
Best suited for: Private lending is best suited for income-focused investors comfortable with moderate risk.
Risks: The biggest risk in private lending is the risk of default. One way private lenders can mitigate this risk is to use a reputable website that vets potential borrowers.
Portfolio fit: If everything goes as planned, private lenders will receive regular principal repayment and interest. Investors can turn to private lending with a portion of their assets to stabilize their portfolio returns and hold assets outside publicly traded stocks or other assets reliant on the performance of a specific market.
Venture Capital
Venture capital investing occurs when investors commit capital to venture capital funds, which in turn provide financing to startups or small companies with impressive growth potential.
How to invest: Venture capital investing is similar to private equity investing, with the main difference in where the capital goes. In private equity investing, the fund buys private companies with hopes to improve the company’s valuation before selling. In venture capital investing, startups or small companies with high growth potential receive the funds.
Best suited for: Accredited investors with a high risk tolerance are best suited for venture capital investing. These investors must also be willing to invest for an extended period without seeing any profits.
Risks: Venture capital investing is, perhaps, the poster child for the more potential for risk, the more potential for high returns. These investments are illiquid.
Warning
VC investing is very risky, partly because of the high failure rate among startups. Additionally, startups do not have a business history to support their strength. VC investors must trust that the fund’s general partners choose strong companies.
Portfolio fit: While venture capital investing is risky, it does add high-growth potential to a portfolio. Venture capital investing also provides exposure to innovation and market disrupters that counter more traditional investments.
Hedge Funds
Hedge funds, like private equity and venture capital investments, use pooled money from high-net-worth investors to earn returns for the investors. However, hedge funds are far more liquid because of the speed at which they aim for uncorrelated returns and underlying investments.
Hedge funds do not focus solely on companies. Instead, they use leverage–borrowed money–to maximize short-term profits through any promising asset, including stocks, bonds, commodities futures, and derivatives.
How to invest: While hedge funds may appear on the outside like a mutual fund or other pooled investment, hedge funds are notoriously less regulated by the U.S. Securities and Exchange Commission (SEC). Therefore, only accredited investors may invest in hedge funds directly through a hedge fund manager.
Best suited for: Wealthy individuals hoping for quick, uncorrelated returns are the target investors for hedge funds.
Risks: Hedge funds are more liquid than similar investments due to the rate at which hedge fund managers work to achieve high returns. The extremely active management of these hedge funds means they have very high fees. These investments are high-risk due to leverage in hedge fund everyday operations.
Portfolio fit: Well-run hedge funds promise outsized returns to match heightened risks, making them a good fit for veteran investors wanting high returns.
Real Estate
Real estate investing means either directly owning physical properties or investing in a vehicle like a real estate investment trust (REIT), which benefits from the real estate market fluctuations without requiring participation in the day-to-day management of the property. Both direct and indirect real estate investors hope to make money from rental income, appreciation, and profits of the underlying property.
How to invest: Investors interested in direct real estate investing buy properties or a part of a larger property like an apartment complex or shopping center. REIT structures mirror similar pooled investments like mutual funds or ETFs. Individual investors enter the REIT market by purchasing shares of publicly traded REITs or public non-traded REITs.
Best suited for: Real estate investing offers investors income and long-term appreciation with a relatively low financial barrier to entry.
Risks: Interest rate changes and economic downturns are the most significant real estate investing risks. Investors should also consider the potential increased risks of sector-specific challenges like poor management.
Portfolio fit: Generally speaking, investors benefit from real estate investment because it offers stability and income to a portfolio.
Crowdfunding
Crowdfunding platforms allow non-accredited investors to participate in projects and business growth without the high income and experience requirements of private equity or venture capital.
How to invest: Those investing in crowdfunding must use platforms or websites such as Kickstarter, Indiegogo, and GoFundMe.
Best suited for: Crowdfunding investing is considered high risk with the potential for high reward. Crowdfunding is best suited for investors attracted to this risk/return ratio without significant amounts of capital.
Risks: Crowdfunding investments are illiquid and rely solely on the success of the project or business that the investor chose.
Portfolio fit: Crowdfunding investments diversify portfolios by allowing investors to invest in unique opportunities with little market correlation.
Commodities
Commodities are raw materials or agricultural products that can be bought and sold. Some of the most well-known commodities are assets like gold, oil, or corn.
How to invest: Investors may purchase physical goods such as gold bars or barrels of oil, futures contracts, or ETFs to participate in the commodities market.
Best suited for: Commodities are seen as a hedge against inflation. This is especially true of precious metals.
Note
Due to the variety of investment opportunities, commodities are some of the most common, most accessible, and most straightforward ways to protect a portfolio against inflation.
Risks: Supply and demand determine the price of commodities, which means unpredictable environmental, political, or geographical events can significantly impact price. Additionally, investors choosing to invest in physical goods have storage costs and risks of loss associated with their chosen commodities.
Portfolio fit: Because commodities tend to move in the opposite direction of stocks, investors can use commodities to minimize the risk of stock performance.
Collectibles
Collectibles are any physical items worth more today than the initial sale price due to supply and demand. Common collectibles include art, antiques, coins, and stamps.
How to invest: Investors must invest directly through dealers or auctions. Investors of collectibles should consider the burden of storage before purchasing.
Best suited for: Collectible investments are best suited for investors passionate about the collectible. These investments are often illiquid and proper storage to retain value is cumbersome depending on the asset.
Risks: The demand for collectibles is not always predictable, but demand directly affects value. Because of this, collectibles are illiquid and at risk for deterioration or loss of value altogether.
Portfolio fit: The market for each collectible is independent of other markets. Collectibles provide diversification in portfolios away from traditional assets while also offering high return potential.
Farmland
Farmland investments involve purchasing farmland directly or through a fund or platform to participate in the profits from farming activities such as food production, raising livestock, or commodities production.
How to invest: Investors in farmland can buy farmland directly and either farm it themselves or high farm managers. Investors hoping to profit without direct involvement in day-to-day activity may invest through funds or platforms like AcreTrader.
Best suited for: Farmland funds or platforms that allow investors to purchase a portion of farmland are best for investors seeking asset appreciation and steady income. The purchase of physical farmland is best for investors passionate about farming or with expertise in the complexities of agriculture.
Risks: While many investors consider farmland investing recession-proof, risks are still associated with these investments. Unpredictable weather is one of the most significant risks of these investments. Additionally, market demand controls prices, and fluctuations in demand can drive profits down.
Portfolio fit: Farmland investing is an income-producing investment that provides stability in portfolios exposed to inflation-affected assets.
Crypto
Cryptocurrencies are digital assets secured by blockchain technology. Supply and demand drive the price of cryptocurrencies.
How to invest: Crypto purchases happen directly through platforms, exchanges, and select mobile providers. Investors interested in cryptocurrency may invest in ETFs to participate in the market without directly owning cryptocurrencies.
Best suited for: Cryptocurrency suits tech-savvy investors with a high-risk tolerance.
Risks: Cryptocurrency is highly susceptible to market manipulations, meaning the asset is very volatile.
Portfolio fit: Cryptocurrency adds diversification to portfolios reliant on the strength of traditional markets. Although both the risk and potential for return are high, cryptocurrency’s market exists entirely outside the markets for conventional investments, which helps minimize risk in those assets while offering maximum returns.
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What is the most popular alternative investment?
Though real estate and crypto are gaining traction, precious metals like gold and silver are still the most popular alternative investments. Precious metals hedge against inflation and are particularly sought after during periods of economic uncertainty.
Are alternative investments riskier than traditional ones?
Alternative investments purchased directly and not through a mutual fund or ETF are generally considered riskier than traditional investments. Part of the associated risks with alternative investments come from market volatility. The majority of higher risk comes from illiquidity and the complexity of the investments.
What alternative investment is more suitable for beginners?
Beginners hoping to invest in alternative investments can look to options like ETFs or mutual funds made up of alternative investments. This will enable them to benefit from the diversification alternative investments offer without assuming the same amount of risk as purchasing them directly,
What investment is risk-free?
No investment is entirely risk-free, but treasury securities are free from default risk. Treasury securities, specifically Treasury bills or T-bills, are backed by the U.S. government and considered the closest thing to a risk-free investment on the market.
Is an ETF an alternative investment?
Exchange-traded funds (ETFs) are not directly alternative investments. However, ETFs are a tool that gives broader access to alternative investments for non-accredited investors. The barrier to entry for many alternative investments is much higher than an average investor can afford. ETFs composed of alternative investments offer these investors the perks of diversification without needing copious amounts of initial capital.
The Bottom Line
Diversification is the foundation of a successful investing strategy. To effectively diversify your portfolio, you must blend assets across various classes, industries, and geographies to minimize risk and maximize returns. Many traditional investments, such as stocks and bonds, help diversify portfolios, but many alternative investments also add portfolio resilience and growth.
Each alternative investment has unique risks, regulatory considerations, and liquidity challenges. However, well-researched investors may find the perfect alternative investment opportunity to diversify their portfolio away from only conventional assets. Accredited investors may participate in many alternative investments directly to target high returns. But, beginners can gain exposure to these high-return investment opportunities through ETFs or mutual funds. These pooled funds reduce initial income requirements and risk.
All investing involves risk, but adequately diversified portfolios through various investments improve the potential for long-term investing success.