Alternative Investments and Risks
Alternative investments identify assets that fall outside of the realm of stocks, bonds, and cash. The all-inclusive term is associated with investments that offer separate risk – reward profiles than that of the prevailing global economy. Although the alternative investment is set up in the name of diversification, these products all carry particular risks within their very own right. The purpose of this article is to define and characterize alternative investments, prior to exposing the price quote, liquidity and opportunity cost risks of these vehicles.
Common definitions of the term “alternative investment” all agree that the class falls outside the traditional mediums of stocks, bonds, and cash. Alternative investments typically require particular levels of sophistication for investors to participate. The Securities and Exchange Commission (SEC) protects the public by limiting particular alternative asset classes to accredited investors. The accredited investor must carry a net worth of at least $1 million or have earned $200,000 in income for two consecutive years.
Alternative Investment Classes
The alternative investment umbrella includes, but is not limited to, hedge funds, limited partnerships, art collections, fine wine, derivatives, timber, real estate, private equity, drilling rights, metals, and rare coins. These investments may not be for sale within organized exchanges and are often bought at private auctions. Alternative investments are always thinly traded and this minimal activity leads to unreliable price quotes, liquidity concerns and overall misunderstanding of the product.
Unreliable Price Quotes
Reliable price quotes are inspired by competition. For example, buyers and sellers will meet to trade over $100 billion of U.S. stock market volume per day and agree upon prices that are quoted by the millisecond, electronically. Conversely, most alternative investments are limited to a small pool of buyers and sellers that meet relatively infrequently to determine price. The lack of activity means that even appraisals handled by experts are open to competition. Investors risk paying more for an asset than it is actually worth. Liquidators risk selling property for less than real value.
Liquidity refers to the ability to convert assets into cash. Alternative investments are illiquid because of the lack of organized exchanges and relatively low level of interest for the asset class. Further, the inability for investors to agree upon the price of an asset leads to lengthy negotiating sessions that can stretch into weeks, months, and years. Investors that carry heavy exposure into alternative investments may not be able to sell off assets in a timely fashion for a good price.
Opportunity Costs, Fees, and Systemic Risk
All transactions feature opportunity costs, which describe the risks of foregoing a more profitable investment in favor of the current move. In the case of alternative investments, imposing fees charged by brokers to manage, buy, and sell the assets must be accounted for in terms of opportunity costs. Fees arrive in the form of a percentage of assets, profits, or commissions to deal property. Alternative investments should feature returns far superior to stocks in order to compensate individuals for these additional costs of doing business.
Some alternative investments are not designed to outperform the stock market, but to neutralize equity volatility by providing steady returns. Still, buyers must recognize that all investments are privy to systemic risk, which is the risk that all entities of a financial system will lose value, regardless of class.