Alternative investments have been around for a long time, but their popularity has grown recently. Should young beginner investors invest in alternative investments?
When beginner investors hear about investing, they first think about bonds or the stock market. However, there are many investment opportunities available outside of traditional investments. However, while traditional investments, like stocks or bonds are well-regulated and easily accessible to beginner investors, alternative investments are less accessible. In addition, not all of them are suitable for young investors due to their complexity and risk levels.
In this chapter, we will take a look at what alternative investments are and if you should invest in them.
Alternative investments are the counterparts to traditional investments like stocks, bonds, cash, or real estate. As a result, they are often called non-traditional investments. However, there is no clear definition of alternative investments. Instead, they include a wide range of safe and speculative investments.
Most alternative investments differ from traditional investments in these aspects:
As alternative investments include all non-traditional investments there are many different types of alternative investments. The most common alternative investments include:
As a young beginner investor, you will most likely start investing in traditional investments, especially stocks. So don’t worry if some of the alternative investments we mention seem complex or difficult to understand. While it is good if you know the basics of these investments, it is not a requirement to start investing.
Index funds and exchange-traded funds (ETFs) are passively managed investment funds that try to replicate the performance of either the whole market or a subset of the market. They do this by tracking a market index that automatically includes specific stocks or bonds based on a predefined set of rules.
A popular market index is the S&P 500, which tracks the 500 largest public companies in the USA. When you buy an index fund that tracks the S&P 500, you will automatically hold shares in all companies included in the index. When a company leaves the index, the fund will sell your shares and replace them with the new company that replaced the old one in the index.
Index fund and exchange-traded funds are very similar in their overall characteristics. However, index funds can only be bought directly from the fund manager. On the other hand, exchange-traded funds, like stocks, can be bought and sold on a public market exchange.
Unlike index funds and exchange-traded funds, mutual funds are actively managed investment funds. Therefore, instead of replicating a standardized, rule-based index, mutual funds employ fund managers that actively pick investments for the fund. Because mutual funds rely on humans to make buy and sell decisions, they tend to have higher expenses than passively managed investment funds.
Cryptocurrencies are digital tokens that are stored and traded on the blockchain. The blockchain is a distributed digital ledger that records and guarantees the validity of all transactions. As a result, every transaction can be traced and they cannot be manipulated.
There are lots of new cryptocurrencies being created frequently. However, due to the lack of regulation, many have been misused to scam people and steal their money. Therefore, you should make sure to only invest in cryptocurrencies that provide a clear value to their users and that have been created by trustworthy people. The most commonly traded cryptocurrencies are Bitcoin and Ethereum, which have become established investments.
When you buy stocks, you invest in publicly traded companies whose stock can be bought and sold by everyone. On the other hand, when you invest in private equity, you purchase partial ownership of a private company that hasn’t gone public in an initial public offering yet. Therefore, the stock of a private company is only available to a small list of accredited and institutional investors. These investors usually are not just contributing money but also providing additional advice, mentoring, and personal connections to the company.
There are three types of private equity:
Private debt is debt that is financed by private persons rather than banks. Companies use private debt when they need additional capital to grow their business. Similarly, private persons might use private debt when established banks are unwilling to lend them money due to their creditworthiness.
While private debt investing can require lots of capital, there are platforms that allow individual investors to invest in private debt and hand out loans to private persons, startups, or real estate developers. Loans given through these platforms are commonly referred to as peer-to-peer (p2p) loans. When you invest in private debt, you will make money through the repayment of the debt and accumulated interest. If the borrower cannot repay the debt, your invested capital is secured through a collateral asset.
When companies are in financial troubles and threatened by bankruptcy, their debt often becomes distressed. It is at risk of default which might leave the debt owner in a situation where he loses his money. Some investors deliberately purchase this distressed debt significantly below its value as they expect the debt holder to recover and pay back the debt.
Investing in distressed debt can be very lucrative. However, it is also very risky and requires a lot of capital. As a result, investments into distressed debt are mainly made by institutional investors.
Hedge funds are actively managed investment funds that invest money for their investors. Their goal is to achieve high returns with a variety of diversified investments. Unlike exchange-traded funds and index funds, hedge funds are exclusively open to institutional investors and high-net-worth individuals.
Commodities are tangible assets, primarily natural resources, such as oil, gas, timber, gold, silver, and other precious metals. These resources are the basic building blocks for producing other industrial products. As a result, they are often not correlated with other financial markets, such as the stock market.
Derivatives are contracts that derive their value based on an underlying asset. Common types of derivatives are options, futures contracts, and swaps. These contracts define specific dates, the value, and the derivative’s underlying asset, resulting in payment between the two parties. Common underlying assets are stocks, commodities, bonds, and currencies.
Some derivatives like swaps and futures bind the contractual parties to the agreed terms over the contract’s life. Others, like stock options, only provide the right to execute the contract without any obligation to do so.
Collectibles are rare items that have a limited supply. As their price is based on supply and demand, the price is artificially increased due to the scarcity of the collectibles. Common examples of collectibles are oldtimer cars, antiques, art, rare wines and whiskey, trading cards, and non-fungible tokens (NFTs). They are risky investments because they have high initial purchasing costs, can be subject to low demand for a long time, and produce no cash flows such as interest or dividends.
Intellectual property describes ownership rights to intangible assets created as the result of creative processes. For example, these can be patents for inventions or literary and artistic works such as music, books, and art.
The ownership rights give the owner the ability to monetize their intellectual property. For example, an artist might earn royalties when their music is streamed on a streaming service. On the other hand, companies can receive licensing fees when other companies use their patents.
As Seth Klarman points out in his book “Margin of Safety”, there is a big difference between speculation and investing. Investing is based on the fundamental underlying value of an asset. On the other hand, speculation is based on predicting how market participants will act and influence the price.
“The greedy tendency to want to own anything that has recently been rising in price lures many people into purchasing speculations. Stocks and bonds go up and down in price, as do Monets and Mickey Mantle rookie cards, but there should be no confusion as to which are the true investments.”
Some of the previously described alternative investments can be considered as real investments. Their value is based on underlying values in the form of assets belonging to the investment, or cash flows that will be paid out. Examples of this include private equity, private debt, or hedge funds.
However, other alternative investments such as cryptocurrencies and collectibles, like art or wines, can be considered speculative instead as they solely rely on supply and demand. Without that demand, they would not produce any meaningful cash flows to their owners and therefore provide no value on their own.
Continue with the next lesson of our beginner-friendly guide “Basics Of Investing”.