Most people are familiar with common investments, such as stocks, bonds, and cash, but there are a lot of other ways to get returns. Alternative investments are essentially those that fall outside of these three conventional categories. This could include real estate, venture capital, private equity, trust deeds, and more.
You may be familiar with the concept of portfolio diversification in terms of having a mix of stocks, bonds, and cash, but there are also benefits to diversifying into other asset classes. Let’s explore some alternative investments and why you might want to include them in your portfolio.
Types of Alternative Investments to Consider
One of the most important things to know about yourself as an investor is your tolerance for risk. Are you willing to take a chance with the hope of reaping a higher reward, or are you more inclined to take the safer bet with a potentially lower return? Here are a handful of alternative investments in relative order from highest to lowest risk to help you determine the right fit for your preferences.
Venture Capital
This asset class comes with the highest risk because it’s essentially a speculative investment. However, it also comes with the highest potential reward. Venture capital works by placing small bets on a portfolio of companies with the hope that some of them will yield high returns. The major downside is that your capital isn’t liquid and often comes with a 7-10-year tie-up period.
Private Equity
Private equity also entails investing in companies through a fund, but the focus isn’t on startups, so the risk is lower. Each fund has its own strategy, but a common approach is to buy companies that already exist and identify efficiencies to increase the value and sell at a profit.
You can invest in general funds or specific areas, such as financials or industrials. This type of investment is also typically longer-term, and success depends on the skills of the people and teams doing the turnaround.
Collectibles
Tangible assets, such as collectibles, are one way to invest, especially if you have a passion or expertise in a particular area, such as sports memorabilia, art, or wine.
The challenge with this asset class is that it’s culturally based, and success depends on deep knowledge of the market, scarcity, and understanding fluctuations in value so you know when to buy and sell. Depending on the type of collectible, it may be hard to sell and, therefore, not very liquid. The tie-up period is also unpredictable, and you may have to engage with an auction house or online marketplace that will cut into your returns.
Real Estate (Direct)
Making direct investments in real estate is historically a sound investment, but it’s never a certainty. Making smart decisions about the types of real estate to invest in depends on the market trends and your interests and could include commercial, industrial, and residential. Strategies include getting cash flow from rent or purchasing for appreciation.
Consider the additional investments you’re making in time, maintenance, and so on if you’re actively managing properties. You can also choose to be a passive investor by outsourcing management, but this also comes with a price. Money invested in real estate comes with the risk of not being liquid—especially if you want to sell in an unfavorable market.
Real Estate Investment Trusts (Indirect)
Instead of investing directly in real estate, which comes with the higher risk of dependency on individual properties and ties your money up for longer, you can invest by way of a fund, also known as a real estate investment trust (REIT). REITs can be either public or private, and they’re more common than you might expect. According to Nariet, REITs own more than $4 trillion of real estate, with public REITs owning $2.5 trillion and private REITs owning $1.5 trillion in assets.
REIT investing comes with lower risk because the portfolio is diversified with hundreds or thousands of assets. This type of investing also offers cash flow with a regular yield, much like investing in bonds, but with slightly more risk. Each REIT has its own strategy and could include direct investment in real estate, debt secured by real estate, or other approaches.
Benefits of Alternative Investments
Including alternative investments in your portfolio can help you manage risk compared to putting all of your capital into traditional investing options. For example, if you have all your money in stocks, your entire portfolio is impacted if the market tanks. Not all alternatives have a correlation to the stock market, which is why many investors choose to diversify with non-correlated assets.
An investor might choose to place a small percentage of their portfolio on higher-risk asset classes, such as private equity or venture capital, with the hope of an outsized return. Balancing the portfolio with a lower-risk asset class, such as real estate, that you’re not actively managing allows you to collect interest income no matter what’s happening with the stock market.
Possible Downsides of Alternative Investments
Every investment comes with possible risk factors, and it’s important to understand them. Ask questions to get comfortable with different types of investments, and consider working with a registered investment advisor or certified financial planner.
When selecting alternative investments, use these criteria to help you evaluate your options:
- Track record: Although not a guarantee of future performance, knowing a fund’s historical performance provides good insights into what yields have been generated in the past.
- Operating agreement: This document outlines how an investor’s money will be used, the various risks associated with the venture, how long the funds will be tied up, and mechanisms for exiting.
- Risk versus reward: Evaluate the potential or loss and how it compares to your own tolerance for risk.
- References: Talk with other investors who have done business with the partners you’re considering.
Consider Construction Loan Funds
If you’re looking to diversify your portfolio with alternative investments, consider construction loan funds that generate yields from the interest collected on short-term debt to develop or improve real estate. A REIT mortgage pool provides capital for the funds, and the asset manager vets borrowers and services loans for ground-up construction, fix-and-flips, major remodels, accessory dwelling units, and other types of projects.
Borrowers typically have a lot of equity in the deal, so it’s low-leverage, and they’re screened to ensure they have good credit scores and a history of building on time and on budget. This asset class is also relatively liquid because once the borrower finishes a project, they convert to traditional financing or sell the completed project.
In general, it’s a good fit for investors who don’t want to take a lot of risk but want to earn more than they can in a money market or savings account.
Invest with Herzer
If a strong track record is important to you, Herzer has a strong history of delivering fixed income backed by real estate. Since 1950, we have funded more than $1 billion in real estate projects in California, yielding solid returns for our investors.
Reach out anytime with questions or apply to become an investor today.
