Any good investor knows the saying “don’t put all of your eggs in one basket”; that is, don’t put all of your money into one stock or even one kind of investment. Stocks, bonds, real estate investments, cryptocurrency—it’s a crowded field out there, leaving many novice investors wondering where to start. In this post, we’ll walk you through why you should be using alternative investments to diversify your portfolio and reap the biggest dividends.
What is diversification?
Diversification is a technique that investors deploy to increase their returns while simultaneously decreasing their overall risk by allocating capital across a broad spectrum of types of investments and industries.
All investors today should understand and use diversification to strengthen their investment portfolios.
What are alternative investments?
Alternative investments are categorized as any financial assets that don’t fall into one of the traditional investment categories, such as:
- Mutual funds.
Some of the most commonly used forms of alternative investments include:
- Hedge funds. These are made by pooling cash from a group of investors and investing it across multiple securities with the goal of keeping risk-managed to outperform the market’s current rate of return.
- Private equity. Investing capital in private corporations, including:
- Venture capital
- Growth equity
- Real estate. Investing in a residential, commercial, or retail property as an individual or group.
- Debt investing. Investors put capital in a private company’s debt.
- Commodities. Investors put money in natural resource investments, including oil, agriculture, and/or timber.
Since alternative investments are separate from the public stock exchange, they offer a unique chance for portfolio diversification. They also offer great potential for high returns because they allow investors to choose from a wide variety of investment options.
All of these factors give alternative investments a higher potential for long-term performance.
Portfolio diversification strategies
In the world of portfolio diversification, there are three main strategies to take into consideration:
- Individual asset diversification. This strategy focuses on investing in various assets in the same asset class; for example, investing in the S&P 500 market index. This helps ensure your portfolio contains an array of high- and low-risk stock options in varying industries.
- International market diversification. This strategy takes things overseas and is particularly helpful when an investor’s home country’s market performs poorly, as they still have their international stocks to rely on, mitigating their risk of significant losses.
- Asset class diversification. This strategy uses diversification through investments across asset classes, which can include traditional investments and alternative investments. Alternative investments are particularly beneficial to add to portfolios thanks to how well they complement traditional assets.
What to consider when diversifying your portfolio
There are many asset types in the alternative investment asset group, each of which comes with its own unique characteristics.
So, how do you decide which ones will work best with your portfolio? Here’s what to consider:
Time horizon and liquidity
The amount of time that investors expect to hold specific investments is known as a “time horizon.” As you can imagine, this varies quite broadly and can be as short as a couple of hours and as long as several decades!
Stocks, bonds, cash, and other conventional investments do not have set time horizons because they are considered fully liquid—i.e., you can cash them out as soon as you need them.
On the other hand, alternative investments are quite illiquid. They also have longer time horizons, which are sometimes set when the contract is signed. Other time horizons are long because the investments are hard to sell or need a long time to gain value, including:
- Hedge funds. These are invested across different asset classes, which means their time horizons can be as short as a few seconds or as long as a few years.
- Private equity. The time horizons are generally about 10 years.
- Real estate. Investing in real estate is a long-term game. There are no time horizons for individual real estate investors, but moving real estate investments quickly is challenging and heavily tied to market performance, which is why most experts recommend holding real estate investments for at least five years.
- Commodities and collectibles. These are two asset classes with long, flexible time horizons because they both need a pretty significant amount of time to gain value. Commodities and collectibles investors must watch the market carefully to know when is the best time to sell.
Markets and industries
You should choose investments from different industries and markets for a diverse portfolio. It’s also a good idea to research industry trends for any private company you consider investing with and choose companies in industries that will complement each other.
For real estate investments, we recommend spreading out your capital among several types of real estate and/or geographic locations.
Risks and threats
One of the main principles of diversification is spreading out investor risk. Alternative investments can provide differing levels of risk.
It’s important to remember that investment options with the longest time horizons are deemed less risky because they allow the market time to correct itself in the event of a downturn.
But if you invest in physical assets, like buildings or collectibles, longer time horizons can provide more time for the asset to be damaged, stolen, or lost—adding more risk.
Alternative investments are critically important for building strong, diversified investment portfolios.
It’s important that investors interested in this strategy take the time to understand as much as they can about portfolio diversification through alternative investments, including liquidity, industry, risk level, and market trends. This knowledge will help you choose alternative investments that mitigate the overall risk of your portfolio while increasing your returns.
When used properly, these investments have the potential to greatly enhance an investment portfolio’s overall risk-return profile.