Investment diversification is the hallmark of a sound investment strategy. While traditional investments such as stocks and bonds are popular, they are also the most familiar asset classes. That is why alternative investments exist as they provide investors with the chance to diversify beyond equities and fixed income. Alternative investments also present other benefits that are not available in stocks and bonds.
Diversification Beyond Traditional Asset Classes
Alternative investments, such as real estate, private equity, hedge funds, infrastructure investments, commodities, and others, can diversify a portfolio and potentially reduce volatility as they have varying degrees of correlation with traditional asset classes.
For instance, the returns on real estate investments often move independently of stock and bond market returns. This can reduce portfolio volatility when traditional assets perform poorly. Diversification can provide an opportunity for better risk-adjusted returns over the long term, which is the goal of any investment strategy.
Income Generation and Capital Appreciation
Alternative investments often offer higher yields than equities and fixed income. For instance, real estate investments can pay regular rent payments, issue mortgage notes that offer regular interest payments, and appreciate over time. Additionally, private equity investments can provide higher potential returns than other asset classes.
On the other hand, assets such as commodities are often highly dependent on current market prices to generate a return. However, they can also provide potential inflation protection by providing a hedge against inflationary pressures. This attribute can help mitigate downside risks by providing investors with a source of liquidity to maintain their purchasing power.
Risk Management and Portfolio Protection
An attractive feature of alternative investments is their defensive nature. These investments can serve as a hedge against inflation and reduce portfolio volatility. For instance, commodities perform exceptionally well during high inflation as they are often the sources of raw materials and other tangible commodities that drive inflation. Similarly, infrastructure investments can shield investors against economic cycles as they generally comprise long-term cash flows, which are stable and less likely to be affected by economic changes.
Certain alternative investments, such as private equity and hedge funds, are specifically designed to mitigate downside risks for investors. These funds are run by experienced managers who have the skills and expertise necessary to manage a diverse portfolio, thereby reducing risks associated with an individual investment.
Access to Unique Investment Opportunities
Alternative investments often present investors with unique investment opportunities that are not possible through traditional asset classes. These investments offer the ability to invest in certain markets that would otherwise be inaccessible. For instance, investing in infrastructure assets or a niche market with a potentially high yield could provide an attractive and sustainable source of profits.
Additionally, many alternative investments provide a vast array of financial instruments with sophisticated structures that could provide outsized return opportunities. These features can be especially appealing to investors looking for long-term financial stability and robust returns.
Long-Term Investment Holding
Alternative investments are typically long-term holdings because of their unique characteristics. An investment in real estate, for instance, requires patience because the asset class tends to appreciate over time, and any significant changes are often costly. Similarly, investing in infrastructure projects by governments or private businesses involves significant capital commitment, and expecting a quick return may not be reasonable.
Alternative investments require a longer investment horizon and may not be liquid for years. Investors should account for the liquidity risk in their overall investment scenario and be aware of this characteristic of these investments.
Alignment of Investor and Manager Interests
Alternative investments, such as private equity and hedge funds, often involve shared interests between the investor and the fund manager. The fund manager’s investment in the fund aligns them with the investor by providing a vested interest in the fund’s success or otherwise.
This synergy amplifies the value of the investment and can result in shared returns between investors and fund managers, meaning that investors become more incentivized to hold on to the investments, enhancing long-term profitability.
Expertise Required for Due Diligence
It is often crucial for investors to have more experience while investing in alternative investments due to the complexity of diligence required before investing. Evaluating and identifying the potential for more commercial and unique investments require patience that requires more specialized knowledge and expertise in such investment opportunities.
The due diligence process is usually more comprehensive, requiring more detailed financial analysis and risk assessments compared to traditional investment vehicles, such as stocks and bonds. As with any investment, this requires adequate knowledge and advice to help make the best investment decision that would provide profitable returns in the long run.
Lower Correlation to Traditional Asset Classes
Alternative investments are generally less interconnected to traditional assets that mean they usually have low correlation coefficients when compared to traditional investments. This feature helps reduce risk and can enhance their diversification appeal, making them effective portfolio stabilizers.
The correlation among investments reduces the likelihood of significant financial losses resulting from seismic shifts in such financial markets. When investors allocate assets to different classes, they can create a diversified portfolio of potentially high-return investments, with different risk profiles that are unlikely to move in unison.
Higher Potential Returns
Alternative investments are usually more riskier than traditional investments but thus provide potentially higher returns to investors. These increased returns are typically associated with their illiquidity, longer investment horizon, and other attributes unique to particular investments.
While traditional investments remain an essential part of a diversified portfolio, alternative investments offer exceptional returns, and investors with the right knowledge, expertise, and strategy often benefit the most.
Another advantage of alternative investments for investors is tax efficiency. This type of investment can often offer tax benefits that are not available to investors in traditional investment vehicles. For example, many private equity investments offer a potential capital gains treatment on profits, which could provide significant tax savings.
Investors who can take advantage of these tax savings could see considerable investment returns, beyond the regular investment returns. For instance, investing in real estate typically comes with considerable tax benefits, including write-offs for depreciation and other tax-deductible items.