High net worth individuals often consider allocating at least some of their portfolio spread toward alternative investments. Diversifying your portfolio with a mix of alternative and traditional investments can help you hedge against market, interest, and inflation risks.
Although traditional investment avenues can produce steady returns, they are also subject to increased volatility, especially during recessionary periods. Alternative investments include most assets outside of traditional stock market equities and bonds.
Determining if alternative investments are right for your situation relies on understanding the different types of investments available, the advantages, and the risks.
Traditional Investments vs Alternative Investments
Traditional investments involve putting money into well-known assets, such as stocks, bonds, and savings accounts. On the contrary, they typically have lower liquidity, less regulation, and limited historical data. These types of investments are seen as a wealth accumulation avenue for high net worth individuals because of the complexity and increased degree of risk.
The goal of both traditional and alternative investments is to generate a return to increase wealth accumulation. However, the governance of each of these investment types differs. There are more stringent regulations surrounding traditional investments, while certain investments, like cryptocurrency, have lagging oversight.
Types of Alternative Investments
Most investments outside of stocks, bonds, and cash may be considered alternative. Common investments include real estate, cryptocurrency, private equity, art and collectibles, and hedge funds. Futures, derivative contracts, commodities, and venture capital are also classified as alternative investments.
Advantages for High Net Worth Individuals
High net worth individuals lean toward other avenues for their money because of the various benefits. One of the top advantages is portfolio diversification. Holding your entire portfolio in traditional investments, like stocks and bonds, subjects you to an increased risk of volatility. Spreading out a portion of your portfolio to include various other avenues hedges against inflation and market volatility, reducing your risk of a large portfolio decline in a single year.
Alternative investments also have the potential for higher returns. With more risk involved, there is the opportunity to see a greater return on investment compared to the stock market. For example, let’s say you decide to invest in a startup. If the startup fails, you will most likely lose your investment, but if the startup is the next “big” thing, you have the opportunity to make a greater return compared to a bond with a 2% interest rate.
Furthermore, alternatives provide exclusive access to different opportunities. Google and Facebook didn’t go public right when their businesses started. Instead, they held private investors until they grew enough to go public. These give you access to early stage companies that have the potential to become the next Amazon or Facebook.
Risks for High Net Worth Individuals
Despite their benefits, there are also risks that high net worth individuals should consider. First, they can present liquidity challenges. Unlike the stock market, many alternative investments take time to sell. For example, if you are invested in real estate properties, the average closing time can be between four and six weeks. This can put you in a tough position if you need free cash flow on short-term notice.
In addition, some investments can be difficult to sell because of a lack of marketability. Not everyone will be interested in gambling on a startup. This contributes to illiquidity and is one of the reasons why these investments are generally taken on by high net worth individuals that can afford to hold investments long-term if needed.
Another risk is high fees and expenses. Due to the complexity, there are greater professional fees and expenses associated with maintaining your investments. Management fees generally fall between 1.5% to 2%of your invested assets. This can add up, especially if you are heavily invested in alternative investments.
Transparency is an additional concern of high net worth individuals. Alternative investments don’t come with pages of data and history like investments in the stock market do. Instead, you should understand your risk tolerance and evaluate quantitative and qualitative information, such as market demand for the startup or market trends relating to cryptocurrency.
The lack of transparency stems from little to no regulations of certain alternative investment industries. The IRS and other taxation authorities didn’t release guidance on how to handle cryptocurrency gains and losses until a few years after these companies got started. This can make it difficult to plan for taxes and strategically grow your portfolio.
Factors to Consider Before Investing
Before you jump head first, you should fully evaluate your situation to minimize risks. First, outline your risk tolerance. How much money can you lose without negatively impacting your portfolio? What are your investment objectives? Identifying these items will help you figure out a favorable allocation between traditional and alternatives.
Moreover, you should also understand your liquidity needs and investment horizon. If you know you are going to need cash in a few months, investing in these might not be the best option. Consulting with a professional can help you determine which investment allocation is right for your portfolio.
Extensive due diligence is another important step to complete before investing. In the due diligence phase, you will assess risk, project future returns, and outline any concerns. Maybe you find that the startup you were considering isn’t as promising as you thought. Uncovering this information before you invest can avoid pouring money into unfeasible investments.
Overall, these can give high net worth individuals access to higher returns, exclusive investments, and added portfolio diversification. However, there are risks you should analyze before shifting funds out of traditional investments or signing that check.
If you are a high net worth individual considering alternatives, it’s best to contact a professional that can guide you on where to start. Expert help is indispensable to minimize risk and maximize your returns.