What Are Alternative Investments?

A large stack of gold bars.
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An alternative investment is exactly what it sounds like: a financial asset that exists outside the scope of traditional investment categories such as stocks, bonds, or cash. You can still use an alternative investment to contribute to traditional investments, but unconventionally, like shorting a stock or arbitraging a stock between two different markets. From cryptocurrency to antiques to film production, a huge variety of assets falls under the larger umbrella of alternative investments. 

Though you can earn a large return on your investment, alternative investments carry a significant amount of risk. Despite being subject to the Dodd-Frank Wall Street Reform and Consumer Protection Act and recent modernization attempts, alternative investments, as well as the financial advisors who manage them, are not as well-defined or heavily regulated by the U.S. Securities and Exchange Commission (SEC) as traditional investments. This lack of oversight makes alternative investments more susceptible to scams, fraud, and suspicious activity.

For this reason, access to alternative investments has historically been limited to extremely wealthy individuals; not only can they afford to make a large upfront investment, but their finances can also afford to take a hit if the investment fails. However, due to more opportunities for investors to take control of their finances, alternative investments are less risky and more accessible to more people now than ever before.

Benefits of Alternative Investments

Despite some of the risks they pose, alternative investments are an increasingly attractive option for many investors. They are a great way to diversify your financial portfolio. Diversification mitigates the risks and increases the stability of all your investments. If one of your investments performs poorly or fails entirely, you still have other accounts to fall back on. 

While it’s important to diversify your portfolio of traditional investments, taking it a step further with an alternative investment provides an additional layer of security to your finances. Alternative investments are not tied to and do not correlate with the stock market or the current value of cash. They hold their value, helping protect you and your finances from stock market volatility and major economic downturns

Additionally, there are more concrete benefits associated with alternative investments. Some alternative investments, such as collectible items and real estate, are tangible, meaning that you have direct ownership over an actual asset. Further, depending on what you invest in, you could also enjoy significant tax benefits. It’s hard to avoid paying taxes on your traditional investments, but alternative investments are not subject to the same tax regulations. In some cases, you may be eligible for certain tax breaks. Essentially, it can be easier to get the most out of your investment.

How Alternative Investments Work

Because the term “alternative investment” refers to many different kinds of investment opportunities and strategies, there’s no single way to explain how they work. The process can vary greatly between investments. It’s crucial to do your research before making any kind of alternative investment so you understand how it works, what risks you’re taking on, and how you can benefit from it. 

If you have the funds available, you can make a new investment that works for your financial situation and helps you meet your goals. Starting fresh with a new investment allows you to go about it properly from the get-go. Making an alternative investment with your available funds is a particularly smart idea if you’ve already pursued more traditional investment avenues. 

You may also be able to convert investments that you already have into an alternative investment; retirement accounts are often used for this purpose. Depending on what kind of retirement account you have, you may be able to roll it over into a new investment. Self-directed individual retirement accounts (IRA) tend to offer the most flexibility, as, unlike employer-based retirement accounts, you can use an IRA to invest in a way that makes sense for you. If you have a health savings account (HSA), you may be able to use it in a similar way.

Common Types of Alternative Investments

Because the definition is so broad, many different assets can be considered alternative investments. Some of the most common alternative investments that are also easily accessible to new investors include:

Real Estate

Owning any kind of residential or commercial property is considered an alternative investment. If you own your home, you are a real estate investor. Because homeownership is a popular financial goal, real estate is likely the most common alternative investment that many people make.

Aside from owning your own house, there are a few different ways to invest in real estate. You can always look into renting out a second property, but if you aren’t interested in being a property manager, you may want to consider investing in a real estate investment trust (REIT). REITs purchase and operate income-producing properties to keep them part of their investment portfolio, rather than to resell them. You can also spread your investment over different properties to reduce risk even further.

If you don’t want to invest in a large company or would prefer to have more control over your investment, you can open a self-directed real estate IRA. You won’t technically own the property (the IRA will) and you can’t use the property yourself, but any income it generates will go straight back into your retirement account. You have to follow fairly strict rules when buying real estate with your IRA, but you stand to see a large return if the value of your property appreciates or you choose to sell it.

Precious Metals

Gold, silver, platinum, palladium, and other precious metals are another popular type of investment. Many still regard them as the gold standard of alternative investment options. Unlike real estate, they aren’t necessarily used as a source of passive income. Instead, precious metals are used to protect against inflation and economic instability. Though traditional investments tend to lose their value during inflation, precious metals tend to remain stable, if not increase, in value. After all, they have intrinsic value as an asset and because they are limited resources, they cannot be inflated.

You don’t need to find stacks of gold bars or piles of silver coins; there are several different ways you can invest in precious metals. If you want to own them outright, you can purchase a certificate representing your ownership, which saves you the hassle of securing and storing physical assets. You can also look into gold exchange-traded funds (ETF) and stock options if you want to invest in companies that mine and trade precious metals, rather than directly into metals themselves.

Another option is to use your retirement account to purchase precious metals, though you’ll need a gold IRA to do so. Gold IRAs are heavily regulated and, if you aren’t knowledgeable about the process, can be difficult to open. However, it’s worth finding a financial expert to assist you, as it can help secure your retirement.

Private Equity

Private equity involves investing in companies that are not publicly traded. This encompasses many kinds of investments, from providing venture capital for startups to funding buyouts of entire organizations. 

While you can invest directly into a company yourself, these types of investments are typically made through a private equity firm. Initial investments can be costly, but some research suggests that private equity investments often outperform investments made into publicly traded companies. There is often more risk involved, but you stand to make a great return on your investment. Private equity EFTs and funds of funds offer a lower investment threshold but may require additional fees and expenses.

If you have the funds available, you can use your cash to make a private equity investment. Retirement accounts are another common way to invest in private equity. If you have an employer-backed 401(k), you may even already have done so, but if you want more control, you can also use a self-directed IRA to make and manage private equity investments. However you choose to invest, keep in mind that while you may receive a large payout, it may take several years — and even up to a decade — to see that money.

Hedge Funds 

A hedge fund uses investments from many different people and employs nontraditional strategies to maximize returns on those investments. They are similar to mutual funds but tend to only be accessible to high-net-worth individuals. Common strategies for hedge fund investments include arbitrage and shorting stocks, but the actual investment strategy can vary greatly depending on who is managing the fund.

Hedge funds are an attempt to protect against shifts in the market. Some managers take an “all-weather” approach to investing to guarantee returns, regardless of how the market or economy as a whole is performing. They are often more fast-paced and liquid than other alternative investments, meaning that you can benefit from your investment more quickly.

Collectibles

Collectibles refer to any items that are now worth more than their original price due to popularity, age, novelty, or rarity. Popular collectible items include wine, fine art, baseball cards, classic cars, stamps, coins, antiques, and jewelry.

This may sound like a more whimsical or fun way to invest, but you have to take care when it comes to collectibles. They can be difficult to acquire and store, and they aren’t as liquid as other investments. Collectibles also don’t bring in income until you sell them, and while you can likely sell them for a major profit, it can be tricky to find the right buyer. If you’re already highly knowledgeable or passionate about a certain kind of collectible, though, you may enjoy the process of collecting and set yourself up to reap its rewards when the time is right.

Ultimately, alternative investments are just that — an alternative. They aren’t inherently better or worse than traditional investments; they’re just another tool to add to your financial tool belt. As long as you’re thoughtful and deliberate about how you invest, alternative investments are a useful strategy you can use to protect your finances and secure your future.