Alternative Investment Risks
We often come across a new client periodically who has been invested primarily in alternative investments at their prior advisory firm. Through research, we find many of these holdings can not be transferred, sold, nor is there a current market for them in terms of- calculating a current fair value. Needless to say, this is usually un-settling to clients, since there is usually little understanding or education on these investments prior to the sale of them. Typically, a spouse had invested the portfolio some years ago and had recently and/or unexpectedly passed away leaving the existing accounts to them to handle. In many cases, there are dozens of holdings in these alternative investments, mostly illiquid, unable to sell or transfer.
Many investors do not consider the risks of illiquidity, lack of portability and/or high costs when turning to alternatives. It’s important to understand the trade-offs and the process of liquidation. Often pre-retirees and retirees begin to invest more conservatively as they age. As earning power diminishes and the need for more income increases, it makes sense to scale back on riskier investments. Traditional investment management, i.e. equity and bond mutual funds, that are managed under the direction of a long-term financial plan can provide liquidity, diversification and transferability.
Here are a few thoughts to consider before choosing alternatives as investments. An alternative asset investment is one that is not normally in a conventional portfolio of stocks, bonds, and cash. Investments such as gold and silver bullion, hedge funds, venture capital investments, and collectibles such as art, antiques, fine wines, stamps, coins, etc., would be considered alternative investments.
Advantages of Alternative Investments
Investing in alternative investments offers the potential for large returns to those who have the knowledge and expertise to understand what they are holding and can handle the risk. Along with higher risk comes higher potential gains. Also, owning non-correlated assets in a portfolio can lower overall portfolio risk and provide the opportunity for greater returns.
Disadvantages of Alternative Investments
Investing in alternative investments requires a high level of knowledge and expertise on the part of the investor. Many of these investments are illiquid. This may make it hard to find buyers and sellers, hard to determine the current value, and may require extraordinary fees and commissions to handle, store, or market. Also, keep in mind, alternative investments are subject to higher level of investment fraud, scams, and schemes than most conventional investments. This requires a higher level of scrutiny and due diligence by the investor. Another factor to consider is investors have found that in periods of financial turmoil many alternative investments may be more volatile and have a higher correlation to traditional investments (such as stocks) than they anticipated. This negates one of their perceived advantages.