Diversification is the cardinal rule for risk management in investing. But for decades, diversification meant spreading investments across multiple industries or economic sectors, while still using primarily stocks and bonds as the modes of those investments.
Today, investors are not only diversifying their portfolios, they are also diversifying the very mechanisms through which they invest. While stocks and bonds still overwhelmingly form the majority of U.S. wealth investment, hedge funds, Real Estate Investment Trusts, working interests in small companies, currency trading and private equity are gaining popularity as very viable alternatives to the traditional portfolio of only stocks and bonds.
There are very real advantages and challenges to each of these forms of investment. Here is a brief look at five alternative investment mechanisms that investors can investigate as new ways to diversify and grow a portfolio.
For investors who were burned in the real estate market during the recent housing collapse, jumping right back into real estate investment might sound like risky business.
But unlike buying a single rental property, Real Estate Investment Trusts are tools that allow real estate investment that is diversified across geographic regions and real estate sectors. We tend to think of real estate as monolithic, but the real estate market is broad and varied. There is much to choose from in the REIT market — trusts that specialize in hotels, malls, commercial real estate, self storage units and international properties.
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Another important distinction when assessing the risk in an REIT is whether the trust is publicly traded or private. Publicly traded REITs are more highly regulated and disclose much more information, making it easier to assess their risk potential.
As the economic meltdown illustrated, real estate can be a risky investment. But real estate can also generate money through both rental revenue and appreciation, making it a potentially lucrative investment, particularly given a housing market that is showing steady signs of rebounding.
Working Interest in Oil, Gas or Mineral Claims
Working interests are used most often to invest in individual oil and gas wells or leases and mining claims and operations. A working interest in an oil lease is a direct investment in a single oil operation and generally requires a very deep understanding of the risks and profit potential of the oil and gas industry, the individual geology of the area and the projected rate of depletion. Given the nature of oil and gas exploration, where drilling can come up dry or tap into a very rich oil or gas pocket, a working interest can be highly lucrative, but also can be highly risky. Working interests are best used as a small percentage of a given portfolio, with the investor understanding that the investment can potentially be lost entirely. Working interests also range in risks. Unexplored well sites in regions with unknown potential, often referred to as “wildcat” wells, are highly risky. Wells in known oil-producing areas are less risky. And least risky of all is buying into an oil or gas well or mining claim that has already tapped into oil, gas or minerals.
In addition to their profit potential, oil and gas investment has distinct tax advantages. A specific tax mechanism designed for oil and gas wells, called a depletion allowance, gives sizable tax deductions to those with a working interest in a well or mine.
Hedge funds are complex investment vehicles that typically require high-level investment and charge significant fees for a highly managed investment fund. Hedge funds employ a complex mix of investment strategies (often holding many investment positions for short amounts of time) with the end goal of “hedging” against downward trends in the market. The advantages of investing in a successful hedge fund is the potential to make money even in a down market by a depending on highly skilled investment managers. Hedge funds are private, require large minimum investments and have liquidity downsides, since money is locked up for a significant amount of time. But high-net-worth individuals with a high investment IQ will see hedge funds as a valuable investment option worth exploring.
Private equity comes in a variety of forms, including venture capital and growth capital. Venture capital is an early stage investment that carried with it more risk and more reward. Growth capital is a later stage investment that typically is financing the transformation of an established company that already has a track record of performance. Private equity firms, like all other investments, are governed by the dynamics of the overall economy. Venture capital firms flourish in growing and innovation-heavy industries like the technology sector, but a deep understanding of the mechanics of the industry is necessary to succeed in such early stage investing.
Although most people think of hedge funds, REITs and private equity when they think of alternative investments, almost anything can be an investment. Vintage car collections, art and wine can all significantly appreciate over time. These investments can be perfect fits for high-net-worth investors who have a passion, and strong knowledge, of these investments. As opposed to buying into funds, stocks or bonds, these investments are very tangible and very real, which appeals to a certain type of investor. For someone with a passion for collecting beautiful art, rare wine or vintage cars, an investment in these items can indulge a passion and protect their financial assets at the same time.