Diversification is the standard advice that savvy investors hear from financial planners and experts. As the theory goes, spreading investments across several different asset classes helps insulate investors from a catastrophic loss in one area. Conversely, by putting eggs in various baskets, chances are greater that an investor will ride a fortuitously strong performance by one asset class, even if only for a small portion of the overall portfolio.
Diversification can be difficult to apply when one sector, such as equities, is moving upward – it may even feel counterproductive to direct your investments elsewhere when performance has been strong recently. However, it's important to keep your eye on your long-term goals by spreading your investments into different areas, as markets can move quickly and often without warning.
Most investors are familiar with the conventional investments types, including stocks, bonds, and even cash. To truly diversify a portfolio, one may need to consider “alternative investments,” which often have a low correlation with traditional investments – in other words, these investments might “zig” if, for example, stocks and bonds “zag.” A few notable alternative investments are highlighted below:
1. Real Estate Investments
Perhaps the most well-known and visible alternative asset class, real estate consists of land and the buildings on it, and real estate can range from residential to commercial to industrial. Real estate investments generate returns through, in the case of ownership, rent and appreciation or, in the case of loans secured by real estate, interest payments. Additionally, an investment in real estate can take on various forms of risk and reward, with ownership---or “equity”—typically posing more risk (and potential reward) than a first-lien real estate loan, as secured loans must be paid back before owners can reap the rewards of any property upside.
Although real estate was hit hard by the recession (along with most other asset classes), the real estate market has witnessed steady growth for the last several years. Diversifiers often favor real estate ownership for its income and appreciation potential, notwithstanding the volatility that comes with it, and real estate debt for its steadier income stream and principal protection that is backed by the “hard” asset.
Fans of the movie Trading Places will recognize commodities as an asset class -- in the movie, the ending rests on the price of orange juice futures. Whereas stocks typically represent the value of owning a company, commodities represent the value of owning raw materials or agricultural products. Gold, oil, wheat, sugar, and coffee are all examples of commodities that can be owned (e.g., buying gold bars) or traded through options or derivatives (e.g., obligation to buy oil in the future at a fixed price regardless of market fluctuation). Investors like commodities as a diversification play because the price of the commodity typically depends more on the supply and demand balance or perception of the commodity (just ask a “gold bug” during times of economic uncertainty or inflation) rather than the performance of particular companies.
A derivative is a security instrument whose value is dependent upon or derived from a specified asset, such as an interest rate, commodity, stock, or bond. The derivative is evidenced by a contract between two or more parties, and the value of such contract is determined by the price of the underlying asset, which can fluctuate. Investors often utilize derivatives to hedge against fluctuations in exchange and interest rates (in other words, locking in a rate that is otherwise subject to market forces) and defaults on credit instruments, such as a corporate bonds. Others enter into derivatives contracts as speculative plays on the specified asset.
3. Private Equity & Hedge Funds
Often reserved for institutions and high net worth individuals, private equity funds strive to acquire ownership interests in companies, increase value in those companies over several years, then provide attractive returns to their investors (and themselves). Private equity can also include venture capital investments in smaller companies that have the potential for extraordinary gains (but come with a higher risk of going under). Hedge funds, which also attract mainly institutions and high net worth individuals, seek to provide high returns as quickly as possible, often trading in liquid assets such as stocks, bonds, commodities, derivatives, and so forth. Investments in these types of funds tend to be illiquid and require a higher risk-reward profile, but these funds can round out a portfolio for an investor looking for longer-term diversification.
With 20 years of experience in real estate development and construction, Walnut Street Finance sponsors a 7% preferred return investment vehicle specializing in secured, first-lien real estate loans in the Washington, DC real estate market.