The risks and drawbacks of alternative investments: What you need to know

Alternative investments encompass a wide range of assets and strategies that fall outside the scope of traditional investments like stocks, bonds and cash. Some common examples include real estate investment trusts (REITs), commodities (such as precious metals, oil or agricultural products), collectibles (like art, wine, antiques and rare coins), structured products and cryptocurrencies.

• Real estate investment trusts (REITs). These are companies that own and manage income-generating real estate properties, such as apartment complexes, office buildings or shopping centers. Investors can buy shares in REITs to gain exposure to the real estate market without directly owning property.
• Commodities. These are investments in physical goods, such as precious metals (gold, silver, platinum), oil, natural gas or agricultural products (corn, wheat, coffee). Investors can gain exposure to commodities through futures contracts, exchange-traded funds (ETFs) or by purchasing the physical assets themselves.
• Collectibles. These are tangible assets that are valued for their rarity, aesthetic appeal or historical significance. Examples include fine art, rare wines, antiques, classic cars and rare coins or stamps.
• Structured products. These are complex financial instruments that combine various assets, such as stocks, bonds and derivatives, to achieve specific risk-return objectives. They can be customized to meet individual investor needs but often lack transparency and liquidity.
• Cryptocurrencies. These are digital or virtual currencies that use cryptography for security and operate independently of central banks. Bitcoin, Ethereum and Litecoin are among the most well-known cryptocurrencies, but there are thousands of others in existence.

Whether alternative investments are a good idea depends on an individual investor's financial goals, risk tolerance and overall investment strategy. While alternative investments can offer the potential for higher returns and diversification benefits, they also come with significant risks and drawbacks that should not be overlooked.

One of the main risks associated with alternative investments is their lack of liquidity. Unlike stocks or bonds, which can be easily bought and sold on public exchanges, many alternative investments have limited or no secondary markets. This means that investors may struggle to sell their holdings quickly or at a fair price, particularly during times of market stress.

Another concern is the higher fees often associated with alternative investments. Many of these assets are managed by specialized investment firms that charge higher management and performance fees compared to traditional investment vehicles. These fees can eat into potential returns and make it more difficult for investors to achieve their financial goals.

Alternative investments also tend to be less transparent than traditional investments. Many are not subject to the same regulatory oversight or disclosure requirements as publicly traded securities, which can make it harder for investors to understand the underlying risks and potential conflicts of interest.

Furthermore, alternative investments often require specialized knowledge to understand and manage effectively. Investors who lack expertise in these areas may be at a disadvantage and more susceptible to fraud or mismanagement.

Exchange-traded funds (ETFs) are investment vehicles that trade on stock exchanges and typically track a specific index, sector or asset class. While some ETFs invest in alternative assets like commodities or real estate, most ETFs are not considered alternative investments in and of themselves.

Traditional ETFs that track broad market indexes like the S&P 500 or the Bloomberg Barclays US Aggregate Bond Index are generally considered part of the traditional investment landscape. These ETFs offer investors a low-cost, transparent and liquid way to gain exposure to a diversified portfolio of stocks or bonds.

However, there are also ETFs that specialize in alternative assets or strategies. For example, commodity ETFs that track the price of gold, oil or agricultural products, or inverse and leveraged ETFs that aim to deliver multiples of the performance (or inverse of the performance) of an underlying index. While these ETFs can provide exposure to alternative investments, they are still subject to the same regulatory oversight and disclosure requirements as traditional ETFs.

Traditional investments are the most common and well-known types of investment vehicles, typically consisting of stocks, bonds and cash equivalents. These assets are generally more liquid, transparent and accessible to the average investor compared to alternative investments.

• Stocks. Also known as equities, stocks represent ownership shares in publicly traded companies. Investors can buy and sell stocks on exchanges, with the goal of benefiting from the company's growth and profitability over time.
• Bonds. These are debt securities issued by corporations, municipalities or governments to raise capital. When an investor buys a bond, they are essentially lending money to the issuer in exchange for regular interest payments and the return of the principal amount at maturity.
• Cash equivalents. These are short-term, highly liquid investments that can be easily converted to cash with minimal risk. Examples include money market funds, Treasury bills and certificates of deposit (CDs).

Traditional investments are often the foundation of most individual and institutional investment portfolios, as they offer a balance of potential returns, liquidity and risk. They are also subject to more stringent regulatory oversight and disclosure requirements, which can provide investors with greater transparency and protection.

Alternative investments and annuities are fundamentally different types of financial vehicles, each with its own unique risks and benefits. In general, alternative investments are not considered as safe as annuities, which are insurance products designed to provide a steady stream of income over a specified period or for the remainder of an individual's life.

Annuities are issued by insurance companies and are typically backed by the insurer's financial strength and claims-paying ability. They offer a level of safety and predictability that is not inherent in most alternative investments. Fixed annuities, for example, provide guaranteed returns and income payments, while variable annuities offer the potential for higher returns through investments in underlying securities, albeit with more risk.

Alternative investments, on the other hand, are subject to various risks that can impact their safety and performance. These may include:

• Market risk. The value of alternative investments can fluctuate based on market conditions, economic factors, and investor sentiment. This can lead to significant losses, particularly in times of market stress.
• Liquidity risk. Many alternative investments have limited or no secondary markets, making it difficult for investors to sell their holdings quickly or at a fair price.
• Regulatory risk. Some alternative investments are subject to less regulatory oversight than traditional investments, which can increase the potential for fraud, mismanagement or other misconduct
• Valuation risk. The complex and often opaque nature of alternative investments can make it challenging to accurately value holdings, leading to potential discrepancies between the stated and true value of an investment.
• Counterparty risk. Some alternative investments, such as structured products or derivatives, involve contracts with other parties. If these counterparties fail to meet their obligations, it can result in significant losses for investors.

While alternative investments can offer the potential for higher returns and diversification benefits, they are generally not as safe as annuities and should only be considered by investors who fully understand the risks involved and have the financial means to bear potential losses.

Alternative investments have become increasingly popular as investors seek new ways to diversify their portfolios and potentially earn higher returns. However, it is essential for individuals to recognize the inherent risks and drawbacks associated with these assets, including limited liquidity, higher fees, less transparency and the need for specialized knowledge. Before considering alternative investments, individuals should carefully assess their financial goals, risk tolerance and overall investment strategy. It is also crucial to thoroughly research any potential investments and consult with a qualified financial professional to ensure that these assets are appropriate for their unique circumstances.

While alternative investments can play a role in a well-diversified portfolio, they should not be viewed as a substitute for traditional investments like stocks, bonds, and cash equivalents, which offer a balance of potential returns, liquidity, and risk. Ultimately, a prudent investment approach should prioritize transparency, regulatory oversight and a clear understanding of the risks and rewards associated with each investment vehicle.