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Alternative Investments and Your Portfolio Part 1 – Why are Alternatives Important

If you invest, you might see companies touting alternative investments. Your own broker or investment advisor might be selling you alternative investments. As a financial advisor, I get inundated daily with investment companies selling me all kinds of alternates to put client money into. It’s such a large part of the investment landscape that I decided to write this two part guide to help the public to understand what alternative investments are, what they can do for you if used correctly, and what the costs and risks are.

Basic Definition: Alternative

The most basic definition of an alternative investment is that it’s not a stock and not a bond. It is something different. Historically, investment portfolios were made up of a combination of stocks and bonds. Stocks (or equities) represent ownership of a company and are traded on a stock exchange. You can buy or sell them at any time (which means they are “liquid”) and it’s easy to determine their value because they are priced all the time. Bonds (or fixed income) represent a loan to a company or government. Bonds are traded on a bond market, but they are not quite as liquid as stocks. That’s because there are so many bond issues, many more than stocks, that the market for an individual bond is actually quite small. Bonds are liquid, they are just slightly less liquid than stocks.

Alternatives are simply investments which are not traded on the stock market and not traded on the bond market.

Why Invest in Alternatives

First you need to understand why portfolios historically contained both stocks and bonds. Stocks have some great attributes. Overall, they tend to go up over time and are a good inflation hedge. Over the past 50 years, the S&P 500 has gone up an average of 11.353% annually to the end of April 2024 (From article by Cory Mitchell, CMT on tradethatswing.com). But the problem is that the stock market is volatile. During the great recession, the S&P 500 dropped 56.8% (2007 high to 2009 low). Drops of 20% are not uncommon, with the most recent in 2022.

Bonds are thought to be safer than stocks and that’s why they are included in portfolios. Bonds earn interest and are generally less volatile. Sometimes bonds are not correlated with stocks, which means when stocks go down, bonds stay the same or maybe go up. Here is a picture of the S&P 500 and the Barclays US Aggregate Bond Index during the great recession:

graphic of &P 500 and the Barclays US Aggregate Bond Index during the great recession

You can see how the bond market went up 19.25% and the S&P 500 dropped 15.95% during the same period. Negative correlation. If you owned bonds in your portfolio, you would have lost less money during this period than if you owned stocks alone.

The problem is that bonds don’t always go up. When interest rates rise, bonds go down. If that occurs at the same time that stocks go down, you can have the bond market and stock market go down at the same time. This happened in 2022. Here is a chart of the same indices during 2022.

graphic of S&P 500 and the Barclays US Aggregate Bond Index in 2022

This is why we feel classic stock-bond portfolios did so poorly in 2022. Bonds were just terrible, and stocks were slightly worse.

Enter alternatives!

The reason to use alternatives is that they “could” not be correlated with both stocks and bonds. Alternatives “might” help you lower the volatility of your portfolio because of this lack of correlation. In other words, if you had a portfolio with some alternatives, maybe you would not have lost as much money in 2022.

Types of Alternatives

Since alternatives are anything which is not traded on the stock market or traded on the bond market, it is a very broad category with many different investments. Here is a list of some of them:

  • Real Estate – investments in individual properties or a fund of properties.
  • Commodities – buying and selling future contracts in hogs, copper, oil, gold, etc.
  • Venture Capital – investing in start-up companies.
  • Private Credit – loaning to companies who cannot borrow from banks or issue bonds.
  • Private Equity – owning equity in companies which are not traded on the stock market.
  • Hedge Funds – Funds which can buy (going long) stock or sell short (going short) stock. Also, can invest in other assets.
  • Option Strategies – Using the options market to generate income, lower risk, or take risks on individual stocks or market indices.
  • Managed Futures – Buying or selling short in the futures markets to follow trends in these markets. Could be commodity, currency, stock market, or other futures.
  • Precious metals – Gold, silver, platinum, etc.
  • Bitcoin and digital currency.
  • Illiquid Assets – Farmland, Art, Wine, etc.

There are so many alternatives, I am sure I am forgetting some.

Risks

There are a number of risks with alternatives which may or may not be present with stocks or bonds. I will discuss the details of these risks in part 2 of this article, but here is a quick list:

  • Liquidity Risk – The risk that you cannot sell an investment for its true value when you need to.
  • Pricing Risk – The risk that you don’t know the real price of an investment because it trades infrequently and it may not trade on a public market.
  • High Expenses – Alternatives may come with high fees which reduce your possible gains.
  • Underlying Asset Risk – Some alternatives may be more risky than they seem.

More to come

Part 2 of this series will go into the risks in detail but also explain some of the alternatives which reduce these risks or have performed well in the past. I will also explain how alternatives can fit in your portfolio to make it better.

An honest, experienced financial planner should be able to advise you on the best portfolio for you. Make sure your advisor explains these alternatives to you and how they make your portfolio better. If you want to discuss your portfolio with me or my colleague, Mike, please reach out to us.

Important Information

Cereus Financial Advisors, LLC (“Cereus”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Cereus and its representatives are properly licensed or exempt from licensure.

This article contains my views and opinions, which are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.  Past performance shown is not indicative of future results, which could differ substantially.

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

Investing always involves risk and one of the most important aspects of investing is balancing risk with your own risk capacity and tolerance.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

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