February 18, 2017 | Joseph Hogue
With stocks at nose-bleed prices and bonds paying next to nothing after inflation, consider these alternative investments for your portfolio
Stocks in the S&P 500 have climbed more than 240% since the low of the 2009 stock market crash and seem to be hitting new highs daily. Against those amazing gains, it may seem counter-intuitive to be talking about putting your money elsewhere but it might just be one of the best investment decisions you make.
Most people think of stocks (or mutual funds that invest in them) when they think of investing. If you are a little more knowledgeable you might think of mutual funds that invest in bonds, or perhaps a mix of stocks and bonds.
But a solid investment portfolio needs more than just stocks and bonds.
Stocks are reaching levels rarely seen on a price-to-earnings basis, increasing the risk of a drop in prices. As for bonds, the Federal Reserve has started raising interest rates which could weigh against bond prices over the next year or more.
There’s another type of investment that can help reduce the risk in your overall wealth while still providing monthly cash and strong returns. The asset class is called alternative investments and it could be a critical piece of your investing strategy.
What is an Alternative Investment?
The definition of an alternative investment mostly lies in its liquidity or an investor’s ability to buy and sell quickly. Investments in stocks and bonds can be bought or sold within a moment’s notice through huge secondary markets.
The dollar amount of stocks traded on the New York Stock Exchange exceeds a trillion dollars daily. Even the smaller market for corporate bonds approaches $28 billion exchanging hands each day.
Contrast this with alternative investments that might not have a secondary market, meaning you must hold the investment to its expiration, or with lockup periods that require you to hold the investment for years.
But there are benefits to buying alternative investments and that lack of liquidity may not be as bad as it sounds.
First, alternative investments help to spread the risk in a portfolio of stocks and bonds. Asset classes; think types of investments like stocks, bonds and real estate, are affected differently by economic factors. Stocks do well with economic growth and modest inflation while bonds tend to better when the economy stumbles and interest rates come down. Adding alternative investments to your portfolio means another level of this diversification and can lessen the ups and downs from stock market swings.
Because of that lack of liquidity, alternative investments generally offer higher returns compared to stocks and bonds. Investors demand that higher return in exchange for taking the risk of not being able to buy and sell quickly.
Turns out, the lack of being able to jump in and out of alternative investments might not be such a problem after all. According to DALBAR research, the average investor earned just 2.6% annually on a stock-bond portfolio over the decade to 2013. That’s against an average return of nearly 8% in stocks and 4.6% in bonds over the period.
The culprit, bad investor behaviors that cause investors to buy when stocks are expensive and then panic-sell when the market crashes. Having to wait out rough patches in alternative investing to reap longer-term returns may just be what investors need.
As the stock market reaches new highs even against economic uncertainty, here’s two alternative investments you might want to check out.
The Oldest Investment on Earth is still Considered Alternative
It might surprise you that real estate is considered an alternative investment but it goes back to that idea of liquidity. Buying or selling physical property involves a month’s long process of paperwork and high transaction fees compared to buying stocks online. Beyond the difficulty of buying or selling your real estate investments, managing your properties can be a headache for individual investors.
The downsides of direct real estate ownership are countered by the fact that few investments have created as much legacy wealth. Commercial real estate returns averaged nearly 12% annually over more than a decade to 2000 and price fluctuations have historically been about half that of bonds, the next most stable asset class.
I have invested directly in real estate since 2001, first through residential rentals and later adding commercial properties to my portfolio. The management headaches can be overwhelming at first but starting a real estate investment group helps to learn how to more efficiently manage your properties and cut costs.
You can also invest indirectly in real estate through Real Estate Investment Trusts (REITs). These are stocks of companies that own and manage commercial real estate. The companies operate under a special tax code that avoids corporate taxes as long as the company distributes most of the annual cash flow to investors. REITs are actively traded just like any other stock and provide a great source of cash flow.
The Social Side of Alternative Investments with Peer Lending
One of the newest asset classes is a product of the social revolution. Peer lending are unsecured loans made to individuals on lending platforms and funded by individual investors. The basic concept isn’t as new as you might think.
In the past, a traditional bank would make a loan and then package that loan with others to sell to investors. Investors bought loan packages because borrowers were obligated to pay the loan back and individual borrower risks could be reduced through the package of many loans.
Peer lending through sites like Lending Club cuts out the banking middleman. Individual investors sign up to the platform to buy pieces of individual loans at a stated interest rate and payoff date. Investors still get the same diversification by investing in many loans and can filter loans on different criteria depending on risk, interest rates and borrower characteristics.
Peer lending is actually one of my favorite ways to invest $1,000 right now. The average borrower on Lending Club has a credit score well over 700 FICO and makes more than the nationwide average for household income. These aren’t the type of borrowers that are going to risk destroying their credit score on a small, 3-year loan.
Historical returns on peer loans have averaged between 5% and 7% with consistent cash flow every month as the loan is paid off. Most peer lending platforms even allow you to select criteria for the loans in which you invest and the platform will automatically reinvest your money from monthly loan payments.
Alternative investments aren’t necessarily alternative in the sense that they are off the beaten path but only alternative by definition. Investing part of your money in real estate and peer loans can help lower the risk in your portfolio and enjoy monthly cash flows.
Joseph Hogue, CFA is an investment analyst and blogger. He runs six websites on topics including personal finance, investing, crowdfunding and making money from home. A veteran of the Marine Corps, he holds the Chartered Financial Analyst (CFA) designation and lives with his family in Medellin, Colombia.