Alternative Investments and Financial Risks

Alternative investments fall far outside the traditional realm of stocks, bonds, cash, mutual funds, and even real estate. This catch-all term defines investments with divergent risk versus reward profiles relative to the global economy.

We think of the alternative investment as another tool to establish real diversification. Still, we must appraise all relevant financial risks before moving forward with any allocation decision.

Accredited Investors

Alternative investments typically require specialized, insider knowledge and financial sophistication to participate. Many of these alternative investment opportunities are only open to accredited investors.

The Securities and Exchange Commission (SEC) defines accredited investors as those carrying more than $1 million in liquid net worth or earning more than $200,000 in annual income ($300,000 if married).

Alternative Investment Classes

The alternative investment universe includes, but is not limited to, hedge funds, limited partnerships, art collections, fine wine, derivatives, timber, private equity, drilling rights, metals, rare coins, and crypto currency. Alternative investments are rarely for sale through organized market exchanges and are typically traded through private auctions and handshake deals.

Be further advised that Web 2.0 technology has further blurred the lines separating Wall Street investors away from Main Street savers. Now, smaller savers eagerly participate in online crowdfunding platforms to fund alternative investments.

Disputed Price Quotes

The New York Stock Exchange clears between $100 and $250 billion in stock trading volume per day. Here, stock prices are quoted by the millisecond. Alternative investments, on the other hand, are limited to small pools of buyers and sellers who meet infrequently to determine valuations.

As such, even price reports calculated by professional appraisers are open to heated dispute. Here, insiders are best able to operate by exploiting market inefficiencies. Amateurs are always at risk for overpaying to buy in.

Thin Liquidity Concerns

Liquidity refers to the ability to convert assets into cash. Alternative investments, again, are illiquid due to the limited niches and lack of centralized exchanges for these asset classes. In some cases, it may take several months of appraisals, litigation, and renegotiation to agree to terms of a deal.

Commissions and fees for agents, lawyers, inspectors, insurers, and title companies add significantly more expense to these complex transactions. Alternative investors are especially susceptible to business and credit risk, if they are unable to liquidate a failing concern in a timely manner to make good on debt service.

Alternative Investment Strategy

Insiders with specialized knowledge may exploit market inefficiencies and mispriced assets that sell for pennies on the dollar. At the same time, well-heeled investors are better positioned to hold illiquid assets for the long-term and weather severe downturns without being forced into untimely fire sales to desperately raise cash.

10X return is a successful private equity investment. Here, one home run is expected to carry a portfolio littered with business failures. The old cliché is forever true: yes, the rich do get richer.

For the general public, alternative investments should be kept to less than five percent of your total portfolio, or money that you can easily afford to lose.