According to investopedia, an alternative investment is defined by what it is not. Almost any investment that is not a stock, a bond or cash is considered an alternative way of investing. Some financial alternative investments are hedge funds, managed futures, commodities and derivatives contracts.
Aside from financial alternative investments there are all sorts of creative ways of investing. People invest in antique cars, coins, gold, racehorses, real estate and many more non-traditional assets. Some collectibles are even considered alternative investments, although the returns on rarity items are risky. Often a creative investor finds a way of making a profit by dealing in goods that are part of a hobby or a passion.
For example, a friend of mine bought hand-knotted rugs for his new home a few decades ago and became interested in the patterns in the rugs. He was good handling money and figured as long as he was buying for his home he may as well learn about the rugs he was buying. It didn’t take him long to begin traveling to Turkey and Pakistan to buy rugs. Was that a hobby?
He began selling rugs to friends and eventually found several shops that sold his rugs on spec. It became an alternative investment that at first paid for his travel and eventually showed him a profit. Rugs are a sophisticated market, but for some they are a legitimate alternative investment.
Getting In The Door
Another earmark of non-traditional investments is the entry threshold. Many alternative investments are only available to accredited investors. Usually an accredited investor has to prove their level of income or amount of savings are above a certain amount. Basically it takes a provable net worth over a million dollars or a provable annual income above $200,000 a year for more than two years.
Why do investment managers want proof of accredited investors? There are a couple reasons. First, there is legal protection. The government takes a dim view of investment managers who sell high-risk investments to individuals who become vulnerable due to the risk exposure of the investment. If grandma becomes indigent because of a failed alternative investment a legal case is likely to follow.
Honorable investment mangers don’t want the headache or expense of dealing with law suites. If there’s money to be made with their investments then legal problems are a hindrance and to be avoided.
The other reason an alternative investment manager (like a hedge fund manager) seeks accredited investors only is to avoid the annoyances that low net worth investors often bring with them. I’ve spoken to investment managers that say a person with lots of money makes an investment and then leaves the manager alone. That investor watches silently from the sidelines.
It’s the non-accredited investors who are frequently on the phone asking questions about the investment in relationship to everything that happens in the alternative market. It’s exhausting and unprofitable.
There are not many guarantees with investment, but alternative investments are fewer than most. Why? There aren’t as many regulations on alternative investment categories. And some of these investments are complex and unlikely to offer liquidity. In other words if you want out, it may take a while.
Because alternative investments are non-conventional there is far less verifiable performance information published about performance. Just think of my friend’s rug program. He didn’t have annual reports about his performance – at least not that he was willing to share with investors. It was an informal investment activity that he built up on his own. When he sold rugs to friends he talked about the long-term value of the rugs and about their use as a home furnishing. He couldn’t guarantee that any particular rug would be worth more in twenty years.
The whole idea of investment is to preserve and enhance wealth. Different people have different needs. People with a lot of money have the advantage of being able to invest a lot of different ways seeking a variety of results. Usually the bulk of the money is invested to preserve wealth. The idea is to gain a return that covers an wealth loss to inflation and then return a modest growth (maybe 2 to 6 percent).
A smaller part of that wealthy person’s money is then freed to use for riskier investments that have the potential of a higher profit return. To protect against the higher risk these investors often spread their money out over quite a few high-risk investments; the theory being that the more different types of investment the more risk is disbursed because one or two of the investments are likely to win.
The losers are then used as tax losses against the winners. In other words, there is often a sophisticated strategy employed to hedge the higher risks of alternative investments. I met a New York investment banker who invested in Broadway plays.
His garage at his second home out in Rhode Island was covered with posters from these plays. Among the many posters I only recognized a few of the play’s names. When I asked him about why so few, he said he only got an occasional winner and the rest were tax right offs against the few winners. He told me he just enjoyed the theater and was investing to get invited to their opening night parties – sometimes he made money too.