Stocks, bonds, and cash are fundamental components of an investment portfolio. However, many other investments can be used to try to spice up returns or reduce overall portfolio risk. Socalled alternative assets have become popular in recent years as a way to provide greater diversification.

What is an alternative asset?

The term “alternative asset” is highly flexible; it can mean almost anything whose investment performance is not correlated with that of stocks and bonds. It may include physical assets, such as precious metals, real estate, or commodities. In some cases, geographic regions, such as emerging global markets, are considered alternative assets. Complex or novel investing methods also qualify. For example, hedge funds use techniques that are off-limits for most mutual funds, while private
equity investments rely on skill in selecting and managing specific businesses. Finally, collectibles are included because the value of your investment depends on the unique properties of a specific item as well as general interest in that type of collectible.

Each alternative asset type involves its own unique risks and may not be suitable for all investors. Because of the complexities of these various markets, you would do well to seek expert guidance if you want to include alternative assets in a portfolio.

Hedge funds

Hedge funds are private investment vehicles that manage money for institutions and wealthy individuals. They generally are organized as limited partnerships, with the fund managers as general partners and the investors as limited partners. The general partner may receive a percentage of the assets, fees based on performance, or both.

Hedge funds originally derived their name from their ability to hedge against a market downturn by selling short. Though they may invest in stocks and bonds, hedge funds are considered an alternative asset class because of their unique, proprietary investing strategies, which may include pairs trading, long-short strategies, and use of leverage and derivatives. Participation in hedge funds is typically limited to “accredited investors,” who must meet SEC-mandated high levels of net worth and ongoing income (individual funds also usually require very high minimum investments).

Private equity/venture capital

Like stock shares, private equity and venture capital represent an ownership interest in one or more companies. However, unlike stocks, private equity investments are not listed or traded on a public market or exchange, and private equity firms often are involved directly with management of the businesses in which they invest.

Private equity often requires a long-term focus. Investments may take years to produce any meaningful cash flow (if indeed they ever do); many funds have 10-year time horizons. Like hedge funds, private equity also typically requires a large investment and is available only to investors who meet high SEC net worth and income requirements.

Real estate

You may make either direct or indirect investments in buildings–either commercial or residential–and/ or land. Direct investment involves the purchase, improvement, and/or rental of property; indirect investments are made through an entity that invests in property, such as a real estate investment trust (REIT). Real estate not only has a relatively low correlation with the behavior of the stock market, but also is often viewed as a hedge against inflation.

Precious metals

Investors have traditionally purchased precious metals because they believe that gold, silver, and platinum provide security in times of economic and social upheaval. Gold, for instance, has historically been seen as an alternative to paper currency and therefore
may help hedge against inflation and currency fluctuations. As a result, gold prices often rise when investors are worried that the dollar is losing value, though prices can fall just as quickly. There are many ways to invest in precious metals. In addition to buying bullion or coins, you can invest in futures, shares of mining companies, sector funds, and exchange-traded funds (ETFs).

Natural resources

Direct investments in natural resources, such as timber, oil, or natural gas, can be done through limited partnerships that provide income from the resources produced. In some cases, such as timber, the resource replenishes itself; in other cases, such as oil or natural gas, it may be depleted over time. Timberland also may be converted for use as a real estate development.

Commodities and financial futures

Commodities are physical substances that are fundamental to creating other products or to commerce generally. Commodities are basically indistinguishable from one another. Examples include oil and natural gas; agricultural products such as corn, wheat, and soybeans; livestock such as cattle and hogs; and metals such as copper and zinc.

Commodities are typically traded through futures contracts, which promise delivery on a certain date at a specified price. Futures contracts also are available for financial instruments, such as a security, a stock index, or a currency. Though the futures market was created to facilitate trading among companies that produce, own, or use commodities in their businesses, futures contracts also are bought and sold as investments in themselves, and some mutual funds and ETFs are based on futures indexes.

Futures allow an investor to leverage a relatively small amount of capital. However, they are highly speculative, and that leverage also magnifies the potential loss if the market does not behave as expected.

Art, antiques, gems, and collectibles

Some investors are drawn to these because art, antiques, gems, and other collectibles may retain their value or even appreciate as inflation rises. However, those values can be unpredictable because they are affected by supply and demand, economic conditions, and the quality of an individual piece or collection.

Why invest in alternative asset classes?

Part of sound portfolio management is diversifying investments so that if one type of investment is performing poorly, another may be doing well. As previously indicated, returns on some alternative investments are based on factors unique to a specific investment. Also, the asset class as a whole may behave differently from stocks or bonds.

An alternative asset’s lack of correlation with other types of investments gives it potential to increase or stabilize a portfolio’s return. As a result, alternative assets can complement more traditional asset classes and provide an additional layer of diversification for money that is not part of your core portfolio, though diversification cannot guarantee a profit or ensure against a loss.

Tradeoffs you need to understand

Alternative assets can be less liquid than stock or bonds. Depending on the investment, there may be restrictions on when you can sell, and you may or may not be able to find a buyer. Performance, values, and risks may be difficult to research and assess accurately. Also, you may not be eligible for direct investment in hedge funds or private equity. The unique properties of alternative asset classes also mean that they can involve a high degree of risk. Because some are subject to less regulation than other investments, there may be fewer constraints to prevent potential manipulation or to limit risk from highly concentrated positions in a single investment. Finally, hard assets, such as gold bullion, may involve special concerns, such as storage and insurance, while natural resources and commodities can suffer from unusual weather or natural disasters. A financial professional can advise you on whether alternative assets have a role in your portfolio, and which types might be appropriate for you.

Copyright 2006-2010 Forefield Inc. All rights reserved.

Securities and advisory services offered through Mutual of Omaha Investor Services, Mutual of Omaha Plaza, Omaha, NE 68175-1020. The information provided is general in nature. It has been obtained from sources believed to be reliable, but no warranty is made as to its accuracy, timeliness or completeness. The information is not intended, and should not be construed as legal, tax or investment advice, or a legal opinion. Consult with your legal, tax or investment professional before taking any action based on this information. This information is not an offer to buy or sell any security. Past performance is not a guarantee or prediction of future returns. Potential investors should review all prospectuses before investing. There is no contractual relationship between Family Wealth Management Advisory,LLC and Mutual of Omaha Investor Services

One day in the late nineteenth century, the steel magnate Andrew Carnegie was being toured around his company’s newest plant by his chief operating officer, Charles M. Schwab. Even as Schwab extolled the plant’s modernity, Carnegie sensed a hesitancy that wasn’t characteristic of his normally ebullient lieutenant, and inquired as to its source. Schwab admitted that there had been significant technological advances since they had started building the plant, and expressed the wish that they’d built it even six months later, so as to capture the new cost-saving capabilities. Carnegie asked how much that would have lowered the cost of production, and Schwab said, “At least four dollars a ton.” Carnegie instantly said, “Tear it down, Charlie, and build it again as it should be.”Andrew Carnegie’s genius (like John Rockefeller’s in oil) was to know that the low-cost producer of any commodity will dominate the market. He knew that if he ran his new but imperfect plant, someone would sooner than later undercut his price, such that instead of recovering the cost of the plant, he’d end up throwing good money after bad by having to run it at a loss.

Welcome to the essential economic concept of sunk costs: the idea that, regardless of what you paid for it, the only real value an asset has is what it will sell for today, or what it will earn (and thus sell for) in the future. The past, you see, is irrelevant to today’s and tomorrow’s value, and your cost, at some point in the past, is the ultimate irrelevancy.

If your parents bought a particularly happy Renoir from some ruined French aristocrat in 1946 for $50,000, and you sold it to the Japanese in 1989 for $80 million, that’s one kind of experience. If you, on the other hand, were the $80 million buyer in 1989, and recently found that the painting couldn’t be sold for more than $60 million, that’s a different kind of experience. But the painting is still the same ineffable, luminous and inexpressibly beautiful work of art it’s always been.

These analogies, though imperfect, may at least suggest a vitally important truth, and one which will become even more important as the equity market continues its recovery toward its levels of a year—and then two years—ago. To wit, your investments do not know what you paid for them, and would not behave any differently if they did. Making investment decisions based even partially on your own (sunk) costs all but insures that you’re going to make mistakes; the only real question is how big the mistakes are going to be.

Near the depths of The Great Panic earlier this year, a friend in his late 40s mentioned to me that he was thinking of moving from a balanced mutual fund (one that contains both stocks and bonds) to an all-equity fund, for its greater appreciation potential over the balance of his working lifetime. I agreed with his reasoning, as who could not. He then asked, “So do I wait until I get even on the balanced fund, and then switch?”

I said, “Tell me again why you would want to do the switch in the first place.” He said again, “Because an all-equity fund has more long-term growth potential than a fund with a significant percentage of its assets in bonds.” Then while you are waiting for your balanced fund to “break even,” I asked, what will probably have happened to the all-equity fund you want to own? After a long silence, he said, “It will probably have gone up even more.”

However anecdotally, this true fable suggests the power of one’s own cost basis to short-circuit rational thought. In this instance, if the thing my buddy wanted to own really had more potential than the thing he wanted to sell—and of course it did—he would in all probability have lost some incremental return by waiting for his balanced fund to return to the price he paid for it. As soon as he stopped focusing on his cost, and started focusing on what he was trying to accomplish (more long-term appreciation for retirement), he saw that.

The reason this issue will become more pressing as the equity market continues its recovery is the intensely human impulse—driven entirely by a morbid obsession with one’s cost—to “get even and get out.” This is, in effect, the act of punishing yourself for the heroic act of hanging on throughout a bitter decline. Once the market (and/or your investments) come all the way back, and emerge into the bright sunshine of new high ground, you cut yourself off from all the marvelous wealth-building opportunities that an expanding economy, restored to health and vitality as it has always cyclically been, has to offer. This has all the elements of tragedy.

Investing, for most of us, is fraught with more than enough emotional peril. Try not to bring any extraneous emotional baggage to the process. Your cost, as intensely personal as it may feel to you, is no factor in what your investments—on their own merits, and compared to other available investments—will do today, next year, and over the balance of your investing lifetime. Try, to the greatest extent possible (and always with your financial advisor’s wise coaching), to think as if the current market price is identical to your cost.

Then simply ask, “Is this the portfolio I would buy today, if I were holding nothing but cash, and if today were the first day of the rest of my investing lifetime?” However you answer that question, the resulting outcome will almost have to be clearer, more rational and more productive than any decisions you make under the cloud of regret that always hangs over an obsession with your cost.

© 2009 Nick Murray. All rights reserved. Used with permission.