Allocating Alternative Investments in a Diversified Portfolio
By: Jeremy Reif, CRPS
Investing in the stock market has been a popular way to grow one’s wealth over the years, but it is not the only option available to investors. Alternative investments, also known as non-traditional investments, are assets that fall outside the typical stocks, bonds, and cash investments. These investments can include real estate, commodities, hedge funds, private equity, and art, to name a few. Most alternative strategies are usually not available inside company 401(k)s.
The main reason for considering alternative investments is diversification, which is the act of spreading out investments across a variety of asset classes, sectors, and geographic regions. Diversification helps reduce the risk of loss in any one investment, as well as balance the overall portfolio. Alternative investments can provide diversification benefits by offering low correlation with traditional investments and by giving access to unique investment opportunities.
Real Estate
One of the most common alternative investments is real estate. This asset class can provide income through rental income as well as potential appreciation in property values. Real estate investments can be made through REITs (Real Estate Investment Trusts), which are publicly traded companies that own, manage, and develop real estate properties. Investors can also invest in real estate directly by purchasing a property or a portfolio of properties.
In non-qualified portfolios, there are some tax benefits on REITs for their investors. REITs are required to distribute at least 90% of their taxable income to shareholders in the form of dividends, and these dividends are taxed as ordinary income. This means that investors can benefit from the regular income generated by REITs, which can help offset some of the tax burden of other investment gains. Additionally, REITs are taxed as pass-through entities, meaning that the tax liability for the income generated by the trust is passed through to the individual investors, rather than being taxed at the corporate level. This structure can result in a lower overall tax burden for investors, as well as greater flexibility in terms of tax planning. Overall, investing in REITs can provide investors with a way to benefit from the income generated by real estate investments, while also taking advantage of the tax benefits that come with these investments.
Precious Metals
Another popular alternative investment is commodities, such as gold, silver, and oil. These assets can serve as a hedge against inflation and provide a way to diversify a portfolio. Commodities are unique in that they are physical assets that can hold value even in times of economic downturns. These commodities can either be owned in physical assets or in more liquid assets in exchange-traded funds (ETFs).
Hedge funds
are alternative investments that use a variety of strategies to generate returns, including short selling, leverage, and derivatives. Hedge funds are often considered to be riskier investments, but they can also offer higher returns. Private equity is another alternative investment that involves investing in private companies, typically with the goal of turning around struggling companies or helping companies grow.
Art
is another type of alternative investment that has become more popular in recent years. Fine art can hold its value over time and provide a hedge against inflation. It can also be a way to express one’s personal taste and style. However, investing in art can be difficult as it requires a certain level of expertise and knowledge of the market. It also usually lacks the liquidity of other forms of investments that were mentioned previously.
Investing in alternative investments requires a different mindset and approach compared to traditional investments. Alternative investments are often less liquid and have higher fees, so it is important to carefully consider one’s financial situation and goals before investing. It is also important to understand the unique risks associated with each type of alternative investment, such as market risk, credit risk, and liquidity risk.
While alternative investments can provide diversification benefits, it is important to keep them in perspective as a small part of one’s overall investment portfolio. Allocating too much of one’s portfolio to alternative investments can increase the overall level of risk and lead to significant losses. As a general rule, it is recommended that alternative investments make up no more than 10% of a well-diversified portfolio.
Alternative investments can provide diversification benefits to a well-rounded investment portfolio. They can offer access to unique investment opportunities and serve as a hedge against inflation. However, it is important to understand the risks associated with each type of alternative investment and to allocate them appropriately within a diversified portfolio. As with any investment, it is crucial to do one’s research and seek the advice of a financial professional before making any investment decisions.