Investors may be tempted to discard the traditional portfolio mix in favor of alternative investments, but they should exercise caution
Markets are volatile, and economists believe the current conditions indicate a challenging period ahead for equities and bonds. Rising interest rates, higher inflation, and wild market swings have recently led to sub-par returns. The turbulence is causing some people to challenge conventional investing wisdom, such as maintaining a well-balanced portfolio mixing fixed-income assets and equities according to a time horizon.
But while it’s wise to regularly assess asset allocations in light of individual goals and within a strategy, it’s also important not to quickly diversify into “trendy” investment vehicles. Here is a case for taking a measured approach and not rushing into alternative investments of the moment.
A brief review of market-related concerns
As economists and market analysts prepare their forecasts for the next six months, global unrest, the lingering effects of the pandemic, and the highest inflation rate since the 1980s are driving worries about a recession. However, there are also positive signs for economic growth, including low unemployment rates, higher wage growth, and rising consumer spending activity. Nevertheless, most economists remain cautiously pessimistic.
Critics of traditional portfolios argue that these mixes won’t provide enough stable growth or realize desired investment returns within a realistic timeframe. But much evidence points to the contrary, as a diversified mix of traditional investments always recovers and performs well over time.
This consistent historical performance doesn’t apply to most alternative investments — and some of the riskiest, newest vehicles have almost no history at all. Thus, individuals considering alternative investments to buttress portfolios should exercise serious caution.
Alternative investments: definitions and risk
While there is no set definition for alternative investments by any government authority, the consensus is that they are any vehicle that falls outside the “conventional equity, income, or cash categories.” Most are not as well-regulated as traditional investment vehicles, and many carry a higher degree of risk.
Alternative investments can apply to anything from tangible items like art, precious metals, and real estate to using derivatives like futures and options to invest in commodities. The definition also includes intangible investments such as complex structured financial products, cryptocurrencies, and everything that falls under the broad, emerging category of non-fungible tokens (NFTs).
Real estate is perhaps the most common and stable alternative investment vehicle. Investing in actual property is one option, as is indirectly investing in real estate through a real estate investment trust (REIT). In addition, income-generating real estate is considered by many to be an inflation hedge and typically offers positive returns over the long term.
However, the risk and stability profile changes significantly as one gets into other alternative investments. Intangible alternative investment options include pooled investments like hedge funds and private equity funds. These vehicles and venture capital opportunities allow for more active involvement in managing assets, but with that comes greater risk, less transparency, and less liquidity.
Then there are cryptocurrencies and NFTs (non-fungible tokens), the most recent additions to the list of alternative investments. These vehicles have entered the mainstream but remain largely unregulated by the SEC. Crypto and especially NFTs were “white hot” among certain investing populations in 2020 and 2021, but crypto markets are suffering a major meltdown in 2022, and many analysts project NFTs to follow. The novelty and volatility of these digital assets make them too risky for many traditional investors.
Both NFTs and cryptocurrency exchanges are also vulnerable to cyberattacks and fraud. And NFTs are riddled with intellectual property issues that could make ownership risky. In addition, the US Securities and Exchange Commission (SEC) has announced its intention to double down on efforts to regulate these markets, both to protect investors and curb their use by criminals. But for now, the crypto markets are still commonly referred to as “the wild west.”
Less regulation, transparency, and liquidity; more risk
Since most alternative investments aren’t traded on public exchanges, they aren’t regulated by the SEC. There is far less transparency around pricing than with traditional investment vehicles and less liquidity. In addition, accessibility to some alternative asset classes is restricted to accredited investors. And because they are not traded publicly, alternative investments tend to perform independently of standard assets.
Nevertheless, alternative investments have become more popular with some institutional investors and high-net-worth individuals who wish to add diversity to their portfolios. Many also believe these asset classes will effectively hedge against inflation risks and market volatility.
But it’s crucial never to lose sight of the big caveat: there is heightened risk with many of these asset classes, especially if there is a potential for higher returns. And there are also often complex legal, liquidity, and tax considerations associated with alternative investment vehicles.
The case for viewing alternatives with caution — and sticking with a well-designed strategy
It is important to remember that market volatility is to be expected, especially in the wake of a global crisis. The financial strategies used by the Federal Reserve and the federal government during the pandemic to buoy the sinking economy have had lasting effects. And both bear markets and recessions are recurring aspects of long-term economic cycles.
But despite these challenges, traditional vehicles have always historically recovered and performed well over time. And sticking to a well-considered plan according to a specified time horizon is the most prudent course. Even in the face of high market volatility, dramatic change is generally ill-advised — unless life circumstances and objectives change significantly. And even in that case, trendy alternative investments are not considered the safest, most consistent course compared to a mix of traditional vehicles like equities, bonds, and perhaps real estate.
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