Investors have traditionally split their portfolios between the two major asset classes, stocks and bonds (I will leave cash out of this discussion.) More recently, a third asset class has been pushing its way into the portfolios of individual investors and, unlike fashions that come and go, this trend of investing in so-called ‘alternatives’ seems here to stay. What are these alternatives and what role can they play in your portfolio?
Alternative assets are, simply, an alternative to stocks and bonds. This implies that if we put into this box everything that does not belong to the other two, we’ll end up with a large collection of heterogeneous assets, including real estate, commodities, hedge funds, private equity, collectibles… you name it. Some of these alternatives are very liquid, have low annual costs, and can be bought with little capital, such as investments in gold and real estate investment trusts (REITs.) Others are illiquid, have high annual costs, and require large investments (e.g., physical real estate and hedge funds.)
Why Alternatives?
Unfortunately, many people invest in alternatives for the wrong reasons. A very typical mistake is to invest in, say, gold because you think that its price is about to go up. But the truth is that there is massive evidence indicating that both individual and institutional investors are unable to successfully and consistently forecast financial variables. Sad but true.
I know, you may think that your insight, or that of someone you know, is superior; that you do know what’s coming next. But there’s also massive evidence indicating that most people are overconfident, meaning that they think they know more than they really do. Again, sad but true.
