What is an alternative investment?
“Alternatives” are investments that are not stocks, bonds, cash instruments, or funds made up of those things. Common ones include gold and other commodities, options and other derivatives, hedge funds, and real estate.
The chief attribute sought in an alternative investment is behavior – price movement – that differs from the regular markets. For example, if you think the stock market is going down, you would like to own something going in the opposite direction. That’s the theory.
Why you should avoid alternative investments
Different is not better
One fundamental problem with alternatives is that regular markets generally go up. Despite occasional down drafts and rare panics, over time wealth is increased by owning stocks and bonds. If the defining characteristic of a particular asset is opposite movement to the market, why put money into something expected to go down? Indeed, options lose their premiums over time, certain commodities have declined over long spells and poorly located real estate has damaged many portfolios.
Gambling is not investing
You have probably seen headlines about massive profits earned in alternative investments. Gold was hot in 1979 and in the years surrounding the financial collapse of 2008. Real estate had a broad boom in the 1980s and upward spurts in various locations as local economic conditions allowed. Certain hedge fund managers gained fame when their firms recorded incredible gains. However, you probably did not see articles highlighting gold’s 21 year drop after 1980 and its fall since 2011. Nor have you seen much about real estate investing since the 2008 financial debacle made a mockery of house flipping and other short-sighted tactics. And those hot hedge fund managers? Turns out their long-term returns are worse than basic index funds and some of their boasted gains not a product of genius, but illegal insider tips.
Basically, anything can go up in value and look like an investment. But that upward movement does not make it one. Alternative investments are speculative vehicles. Committing money to this sector instead of stocks and bonds is a gamble – actually two gambles. First, by taking money out of the market you gamble on stocks and bonds not generating returns for a spell. This is market timing, a technique demonstrably harmful to investors. Second, you are gambling on the alternative security. It may go up. It may not. Over time, it will most likely go up far less than the stocks and bonds you gambled against, as experience has shown.
What you should do instead
If your interest in alternative investments is anticipated pie-in-the-sky returns, come back to earth and seek the solid gains obtainable in the stock and bond markets. Avoid the tempting thought you know more about gold, land or derivatives than the professionals whose opinions are already reflected in current prices. And resist the claims of salespeople pushing alternative products and hedge funds; bad holdings coupled with huge fees is a recipe for disaster.
If your interest in alternatives arises from extreme market fears and a desire for capital preservation, your tolerance for risk may have shifted. Consider selling some of your stocks or stock funds and either hold the cash generated or buy some short-term bonds or CDs. Once your fear subsides and your risk tolerance shifts back in the other direction, return to your longer-term, risk appropriate asset allocation.