What’s the first thing that comes to mind when you think of the word “asset”? Most likely, stocks, bonds, cash-related instruments, or other traditional investments will come to mind.

However, the investment universe is massive, and these traditional investments only make up a portion of what’s out there.

For instance, alternative assets are a category of non-traditional investments that includes things like real estate, private equity, and hedge funds. Over the years, investor interest has swelled—and alternative assets have thrived.

For example, Preqin, a data intelligence provider, notes that the market for alternatives could swell to a staggering $14 trillion by 2023. But what’s the reason for this boom?

Some experts argue that diversification and higher returns are the primary drivers behind this explosion in popularity. Others contend that lower minimum investment amounts—a welcome trend that has allowed those with smaller portfolios to participate—may have also made alternatives more practical and popular for many smaller-scale investors.

But before we talk about whether or not alternatives can benefit your portfolio, let's first touch on the basics.

What are alternative assets?

Alternative assets have actually been around for a while—for as much as a good few centuries, to be precise. Some records trace them back to the Industrial Revolution in the 1800s. The financial structure of banks at that time faced several rigorous restrictions, so individuals opted for investments in projects like the acclaimed transcontinental railroad (or “Overland Route”) instead.

Fast-forward to some 200-plus years down the line, and alternative assets are still flourishing—and arguably at the cusp of a second renaissance.

Cryptocurrency

For example, cryptocurrency is among the latest inventions in this sector. In 2009, a group of programmers (who are also presumed to be a single programmer) using the pseudonym Satoshi Nakamoto created Bitcoin—a type of digital money not backed by real assets or tangible securities.

In the 13 years since Bitcoin’s launch, thousands of new cryptocurrencies have followed, including Ethereum, Cardano, Ripple, Litecoin, and more. Many retail brokers have embraced cryptocurrency, and new services—like cryptocurrency exchanges, blockchain applications, and token marketplaces—have come online.

Even celebrities and financial moguls—like Elon Musk, Jack Dorsey, and others—have shown substantial interest in this new asset class, deciding that it’s worth a shot. Some, like Dorsey, have taken it even further. A so-called “Bitcoin maximalist”, he believes that the digital currency will come to replace all other currencies in the future—including current-day staples like the U.S. dollar.

But it’s not just the rich and famous who have come to take a liking to cryptocurrency. Digital assets have also spread like wildfire among the broader public—and it’s easy to see why.

Notably, Bitcoin has been performing exceptionally well, beating equity indices by a massive margin. As a case in point, the S&P 500 returned 277% in the ten years beginning January 1st, 2011. Good stuff alright, but this was nothing compared to Bitcoin—which returned an eye-watering 437,171% in the same period.

However, one notable downside is that its prices are highly volatile, making it a rather risky asset to have in a portfolio. Moreover, the risk of the asset being outlawed down the road also compounds the uncertainty clouding the future of this asset class.

Nonetheless, if history is a good guide, it may be possible that cryptocurrencies continue to leave equities in the dust—likely a good reason why it continues to attract so much investor interest.

Private equity

Aside from crypto, another major alternative asset is private equity.

In essence, private equity (PE) involves capital amassed from a group of private investors—usually either institutional or (accredited) retail investors. This money is then used to buy ownership (or equity) in private companies directly.

Alternatively, private equity investors may engage in public company buyouts, a situation where a publicly-traded company is acquired and then taken private.

The private equity sector is broad and incorporates the following investment types: 

• Venture capital (VC): Making a venture capital investment entails pooling money from investment companies, large corporations, or pension funds by an individual or a firm. Afterward, they use this money to invest in small, early-stage startup companies. Generally, venture capitalists invest more money into startups than angel investors do, but write smaller checks than late-stage growth equity or Pre-IPO funds do. 

• Angel investment: Similar to venture capital, angel investing also involves putting money into early-stage startups. However, the difference is that angel investors overwhelmingly use their own money to invest in small companies. Angel investors may also be more involved in helping the business grow. For instance, angel investors may serve on boards, connect founders with potential clients or customers, or offer warm introductions to VCs. To be an angel investor, you should be accredited, which means having an annual income of at least $200,000 or a minimum net worth of $1 million.

• Pre-IPO investment: Pre-IPO investments involve buying shares of private companies that are slated to go public via an Initial Public Offering (IPO) in the near future. Typical Pre-IPO investors include institutional investors like hedge funds and private equity firms. However, retail investors can occasionally secure Pre-IPO placements via private secondary markets.

Suffice to say, the private equity industry is quite expansive. In addition to these asset choices, PE encompasses many other investment types, such as growth equity, leveraged buyouts, private equity real estate, and more.

Are alternative investments lucrative?

Next, let’s talk a little about the return profiles of alternative assets, and how they stack up against traditional investment choices. 

• Cryptocurrency: Despite the significant risks that come with investing in cryptocurrency, this asset class has consistently outperformed its peers. For example, in 2021, Bitcoin returned a whopping 70%, outstripping gold’s measly 4% by a long shot.

• Private equity: Because private equity isn’t marked-to-market on the daily, it appears to experience less volatility than its public counterpart. However, this is largely illusory, as PE’s return profile also fluctuates greatly depending on market conditions, macroeconomic forecasts, interest rates, and other variables. In some instances, like the 20-year-period between 2000 and 2020, private equities registered average annual returns of 10.48%—outperforming both the S&P 500 and the small-capitalization Russell 2000 indices. However, in other instances, private equity’s performance may not be as stellar. Between 2010 and 2020, PE’s annual average performance stood at 13.77%—a figure that trailed the S&P 500 by 0.22% per year.

While alternative investments have performed well—at least in hindsight—it’s difficult to say with much certainty if alternative assets can maintain their outperformance relative to mainstream investments down the line. As the oft-quoted cautionary statement states, “past performance is not a guarantee of future results''. In short, sometimes they'll be more lucrative—and sometimes they won’t be—depending on a nearly limitless host of factors.

Could alternatives be right for you?

While there isn’t a bright-line test to determine if alternatives have a place in your portfolio, you can rely on a few heuristics. In particular, if you’re eager to pursue high rates of return—and also feel prepared for the sometimes stomach-churning levels of volatility, the chronic illiquidity, the lack of regulatory protection, and the ever-lurking investment scams that accompany alternative assets—then you might be ready to give them a go.

Given these caveats, it may be wise to approach alternatives as an opportunity to diversify your portfolio—rather than take to them as a sole strategy for a long-term investment plan. In other words, don’t make alternative assets your core allocation—they’re alternatives, after all. 

However, these aren’t the only things you’d want to consider before taking the plunge into the world of alternative assets. Beyond your psychological preferences, you’ll also need to take into account more practical factors as well.

Are you accredited?

For starters, you may want to look at your net worth and your annual income. Does your net worth exceed $1 million—or do you have at least a $200,000 annual income? If your financial capabilities are within this range, you’ll qualify as an accredited investor, and may be in a position to consider the full spectrum of alternative investments in existence—including many products that aren’t available to the general public.

If you don’t meet these criteria, you can still invest in certain alternative assets (like cryptocurrencies), but you may be barred from investing in a large majority of private equity offerings. If this happens to be you, maybe it would be wise to stick to conventional investments instead.

Are you risk-tolerant?

Next, you may want to consider how comfortable you are in a high-risk, high-return environment. In the event of a significant loss, will you be able to weather the storm and make it out mostly unscathed?

If not, you may want to back away from the alternative investment universe. But if you still want to partake—perhaps for the sake of portfolio diversification—you can consider allocating a small amount (between 5% and 10%) of your total net worth to alternatives.

Other factors—like how well-acquainted you are with the alternative investment space—can also help you decide if they’ll fit well into your portfolio. As with any potential market or individual investment, you should be experienced and know your way around the sector.

While you don’t have to be a professional investor, software engineer, or small business owner in order to put your money in private equity, crypto, or startups, you should be able to articulate what alternative investments are and how they work. You should also be familiar with their benefits, risks, drivers of value, and other important characteristics.

That said, everyone starts somewhere, so you shouldn’t expect to know any of this right off the bat. However, before you sink real money into cryptocurrency or your friend’s cousin’s drinking buddy’s startup, you should first familiarize yourself with the alternative investment industry by studying books, browsing online resources, or by consulting with experts in the field.

If you still feel like it's worth investing in alternatives after doing your due diligence—then by all means, go for it. However, remember to approach it carefully—only after thoroughly and seriously considering all associated risks. But if, after doing so, the idea doesn't sit well with you and seems too great a risk, then you may want to consider sticking to just stocks and bonds.

Conclusion

It's typical for a great deal of investor portfolios to be filled by stock and bond. After all, they’re widely considered to be the dominant traditional asset classes. However, adding variety to portfolios through diversification has often positively impacted investment performance—both by reducing idiosyncratic risks and by ramping up returns. For this reason, alternative investments—like private equity, hedge funds, cryptocurrency, and venture capital—may be a solid add-on to your portfolio.

If you want to get a feel for alternative assets without betting the farm on them, it may be wise to allocate a limited portion of your portfolio to alternative assets—say approximately 10%. Do this correctly, and you may optimize your portfolio for higher returns in the long run. 

However, before making a stand to venture into alternative assets, it'd pay to analyze if they make a good fit for your situation in particular. Go over your investment potential and your financial standing. Are they in line with the criteria for investing in alternative assets?

Finally, keep in mind the one prominent trait among most alternative assets: they're high-risk, high-return ventures. So, if this sounds like something you can get behind, then you may want to consider having a go at building a portfolio from alternative assets. Otherwise, perhaps a simple split between stocks and bonds—two tried-and-true asset classes—will do just fine.

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