The concept of investment, over the years, has proven to be beneficial for investors in many ways. Whether it is a means of potential passive income options or an opportunity for high returns, investments are of assistance during the long run. Furthermore, it is also seen as a plausible approach toward portfolio diversification. The term “diversification” can be easily understood as synonymous with the phrase “Don’t put all your eggs in one basket.”
Investment professionals agree that diversification is the most crucial part of achieving long-term financial goals and minimizing risk, despite the fact that it does not guarantee against loss. A variety of investments can contribute to the diversification of the portfolio, including alternative investments.
However, before moving forward with the relationship between alternative investment and portfolio diversification, it is necessary to comprehend what this type of investment means. Read on to know more!
What is Alternative Investment?
Alternative investment or formally known as an alternative asset, covers investment that is apart from the traditional aspects like stocks, bonds, and cash. One of the most dynamic asset classes, alternative investments offer a wide range of unique characteristics. Alternative investments include assets such as real estate, private equity, hedge funds, commodities, and art, among others. They are called “alternative” because they are less commonly used and often considered less mainstream than traditional investments. Alternative investments can offer the potential for higher returns but also come with higher risk and typically require a significant amount of money to invest. They are often used as a way to diversify a portfolio and enhance overall returns.
Further, it has been estimated that the Global Alternative Investment market is expected to grow 18-24% by 2025.
The Need for Portfolio Diversification
While on the investment journey, one should be cautious and take steps that mitigate risks. One such step is portfolio diversification. The process of portfolio diversification is not just limited to amplifying the returns; it also reduces the impact of market volatility. As a means of portfolio diversification, many professional investors advise building a 60/40 portfolio, allocating 60% of capital to stocks and 40% to fixed-income investments such as bonds.
Further, this process allows businesses and investors to inculcate liquidity and can help them tap different sectors. Let’s take an example to understand the need for portfolio diversification. If one has invested only in airline stocks, following a piece of bad news, the share prices are sure to drop, resulting in decreasing value for the portfolio. Alternatively, while the airline shares see a fall, it is expected the railroad stocks see a splurge. At the heart of diversification is the proactive balancing of different investments in one’s portfolio.
The above-mentioned chart is an exquisite example of a diversified portfolio.
Creating a Diversified Portfolio with Alternative Investments
Alternative investments are separate from traditional securities, thus, offering a unique and new perspective for portfolio diversification. However, there are certain steps or factors that need to be taken into consideration before opting for alternative means of investment. Some of these are:
- Time Horizon and Liquidity: An investor’s time horizon is how long he or she expects to hold a specific investment. The duration of time horizons varies greatly, from a few minutes to several decades. Investments with a long time horizon are considered illiquid until they mature since their time horizon determines liquidity. Cash, stocks, and bonds (traditional investments) are liquid assets and do not have a fixed time horizon. Compared with traditional investments, alternative investments have much longer time horizons and are relatively illiquid. For some alternatives, time horizons are set at signing a contract; for instance, when someone becomes a limited partner at a private equity firm.
- Industries: While choosing alternative investments, it is advised to surf through the various markets and industries to get familiar with the ongoing trends. For instance, when considering real estate investments, spread out the capital between several real estate types or geographic locations.
- Potential Risks: Before investing, it is always a smart decision to look for potential risks, as each risk associated with the type will help an investor in choosing the right alternative investment option.
Let’s take a look at the possible alternative investment opportunities that an investor or a business can use for portfolio diversification.
- Gold and Other Precious Metals: The most common of precious metals, gold, and silver, are among the best alternative investment options. Further, they are also considered a great means of portfolio diversification. Gold, in particular, has a long track record of holding its value-or, even increasing in value during times of slow markets, making precious metals an asset class that investors could use to protect themselves against market downturns.
- Agricultural Commodities: Another excellent option for alternative investment is investing in commodities. Due to the high significance of agricultural commodities to both society and the economy, they are great for portfolio diversification. If demand and supply remain balanced, prices will typically remain stable. It is common for agricultural prices to rise during times of inflation. This is an excellent way to protect one’s portfolio from a decline in the stock market. A total of $1.109 trillion was generated by the US agriculture sector in 2019 based on gross domestic product.
- Real Estate: It has been estimated that portfolios with 10% alternative investment in real estate are known to outperform. Real estate should be added to the portfolio of investors seeking higher portfolio diversification. It has historically been reported that real estate has increased a portfolio’s total return and reduced its volatility.
- Music Royalties: Another diverse option for investment option is music royalties. Several sites exist today where musicians and investors can buy and sell music rights, allowing musicians to sell some of their music rights and investors to buy music rights for royalties. One can invest in song royalty and other kinds of music royalty investments, book publishing royalties, TV royalties, and movie royalty investments through a number of these platforms. Investments in music royalties can generate passive income streams for investors or businesses.
The Last Word
Alternative investment, be it in hedge funds, private equity, or collectibles, can be a great way of creating a strong and diversified investment portfolio. However, understanding the time horizons and potential risks associated with the investments can be the deciding factor in carrying out alternative investments. An investment portfolio’s overall risk-return profile can be enhanced by the use of these investments when used correctly. Researching thoroughly about alternative investments can help you determine the most suitable choice for you. For more information related to alternative investment and how you can carry it out, head over to the Bhive Alts website.