Have You Figured Out Your Alternative Investment for Wealth?

Here’s a question you may never have asked. What do millionaires do with their money?

For millionaires, investing in real estate has been the most popular way to preserve their wealth. In addition, index funds and dividend-paying stocks are also popular with those seeking simplicity.

However, investing in the stock market is not something that the world’s richest people do. They invest a large portion of their net worth in alternative investments.

In 2020, high-net-worth investors (those with a net worth of at least $1 million) allocated 26% of their assets to alternative investments, according to KKR. Additionally, alternative investments accounted for 50% of the assets of ultra-high-net-worth investors (those with a net worth of more than $30 million).

Alternative Investments

To put that into perspective, alternative investments typically represent a small percentage of an investor’s total portfolio. The Chartered Alternative Investment Analyst Association reports that about 5% of retail investors’ portfolios contain alternative investments.

Moreover, 75% of high-net-worth investors between 21 and 42, versus 32% of investors over 43, don’t expect “above-average returns” from traditional stocks and bonds alone, according to a study released by Bank of America Private Bank.

Further, 80% of these young investors are looking for alternative investments not part of traditional asset classes. Younger investors allocate three times more to alternative assets than to other generations and half to stocks.

Want to know why? Christopher Schelling, the Director of Alternative Investments for Venturi Private Wealth, can answer that question.

In addition to investing roughly $5 billion, Chris has met with over 3,000 managers across private equity, real estate, private credit, natural resources, hedge funds, liquid alternatives, and crypto. As well as being the author of Better than Alpha: Three Steps to Capturing Excess Returns in a Changing World, he has over 20 years of investment experience, nearly all of them in alternative investments.

Along with his expertise, we will discuss alternative investments, institutional investing, private credit funds, investments in private companies pre-IPO, cryptocurrency, and more.

What are Alternative Investments?

“[Alternative Investments] are probably best defined by what it’s not, and it’s just simply everything other than traditional stocks and bonds,” explains Chris. While they tend to be illiquid and more complicated than traditional investments, they can also provide higher returns.

An alternative investment can be one of the following types:

• Private equity. An investment in a private company, commonly through a venture capital fund or a buyout fund. Private equity firms typically acquire control of a company and improve its performance to make a profit.
• Hedge funds. Hedge funds are investments that generate returns using a variety of strategies. It is common for hedge funds to leverage their investments by borrowing money. There is a potential for maximizing returns but also a possibility for increasing risk.
• Real estate. Property ownership, either directly or through a real estate investment trust (REIT). In the long run, real estate can be a good investment because it appreciates in value. As a result, it can be difficult to sell real estate quickly if it is illiquid.
• Commodities. A raw material is something like oil, gold, or wheat. In comparison to stocks and bonds, commodities tend to be less volatile. It is worth noting, however, that commodities can also be cyclical, meaning their prices can rise and fall over time.
• Art and Collectibles. Collectors and investors seeking diversification will often invest in tangible assets such as fine art, rare coins, and vintage cars as they appreciate in value over time.
• Cryptocurrencies. Regulatory uncertainty and high volatility have made digital currencies like Bitcoin and Ethereum increasingly popular in recent years.

A cool thing about alternatives is that there are no restrictions, says Chris. In addition, you can find niche areas with interesting returns.

Benefits of Alternative Investments

The following benefits are associated with alternative investments:

• Potential for higher returns. Compared to traditional investments, alternative investments are capable of offering higher returns. Due to their lower correlation with the stock market, they often provide greater diversification.
• Diversification. Investing in alternative assets can reduce risk and diversify a portfolio. In diversified portfolios, investors are less exposed to any one asset class than they would be if they invested solely in one asset class.
• Protect yourself against inflation. During inflationary periods, commodities and real estate tend to perform well, preserving purchasing power.
• Having access to unique opportunities. Through alternative investments, investors gain access to markets and assets unavailable through traditional channels.
• Income generation. It is possible to generate income from alternative investments in various ways. A real estate property can generate income through rent, and commodities can generate income through interest or dividends.
• Portfolio stability. While alternative investments may not always follow broader market trends, they can help stabilize a portfolio during volatile times.

Moreover, Alts are growing at twice the rate as institutional assets, adds Chris. In other words, it’s larger, growing twice as fast, and hasn’t really penetrated the market yet.

Considerations and Risks of Alternative Investments

The following are some of the key risks associated with alternative investments:

• Illiquidity. There can be difficulties in selling alternative investments quickly due to their illiquidity. Investors who need access to their money quickly may have a problem with this.
• Risk. Compared to traditional assets, many alternative investments have a higher risk profile. Before investing, perform thorough due diligence and evaluate your risk tolerance.
• Complexity. It may be difficult to understand alternative investments due to their complexity. As a result, it can be challenging for investors to determine the investment’s risks and potential returns.
• Expertise. It is necessary to possess specialized knowledge and expertise when investing in alternative investments. Don’t make any decisions without consulting a professional or getting extensive information.
• High fees. The fees associated with alternative investments can erode returns.
• There is often less regulation for alternative investments than for traditional investments. In the event of a problem, investors will have less protection.

How to Grow Your Wealth With Alternative Investments

While alternative investments can be a great way to build wealth, they are not risk-free. By following these tips, you can invest in alternative investments and increase your wealth:

Take the time to educate yourself

Understanding the different types of alternative investments is essential before investing. The types of investments may range from real estate to private equity to venture capital to hedge funds, commodities to cryptocurrencies to art. The characteristics and risks of each alternative investment are unique.

Take private credit, for example, Chris says. In contrast to the public markets, they don’t have access to the same amount of capital. Due to the lack of realized risk, you’ll have to manage the downside. One way to do this is through senior secured lending to middle-market businesses. Generally, you have higher capital stacks, better collateral, and better cash flow coverage than a publicly traded corporation with similar debt. If you’re in the mezzanine, you might even get warrants as well as a higher coupon.

In short, before investing in any alternative investment, make sure you do your research and understand the risks. It is important to understand the asset class, the manager, and the fees associated with it.

Set financial goals and determine your tolerance for risk

Next, you’ll want to identify your financial objectives and assess your risk tolerance level. It is important to remember that alternative investments can be volatile. Therefore, knowing your risk tolerance and investment horizon is crucial.

To determine your risk tolerance, consider the following questions:

• What are your short-term financial goals? Among these are saving for a down payment on a house, paying off debt, or taking a vacation.
• What are your long-term financial goals? Some examples include saving for retirement, paying for your child’s college tuition, or starting your own business.
• How much risk are you comfortable with? Answering this question is a matter of personal choice, and there is no right or wrong answer. Risk-taking is comfortable for some, while safety is more important for others.
• What is your time horizon? When will you need to use your money? This is your time frame. You will need to take less risk if you need the money quickly. It is okay to take more risks if you have a longer time horizon.

Turn down the wrong deals

“It’s not about the deals you say YES to; it’s about all the deals you say NO to,” says Chris.

He adds that if you’re a wealth management firm and you’re given the choice of four or five private credit funds, the chances of picking one are pretty slim. If, on the other hand, you choose ten of a thousand private credit funds, your probability is much higher. In addition to spotting the better deals, you have now established a process for evaluating them over a much broader set of characteristics.

Chris calls this learning process “smart habits.” As you accumulate more data points, your decisions will become more accurate. As you see the funds, you think, “Oh, they did it this way, and it was really good. They did it this way, and they were really good.” However, now they are not so good. So, the most essential things reveal themselves through iteration. “I looked at 3,500 managers and said no 3,400 times,” Chris states.

Begin small

Investing in alternative investments can be intimidating if you’re new to them. Taking this course will help you understand the ropes and determine whether you are comfortable taking risks.

As you gain experience and comfort with alternative investments, you should increase your exposure gradually.

Work to eliminate behavioral biases

Many people believe they’re making economically sound decisions when buying and selling. This is simply not true. It is pretty well known that we make emotional decisions based on heuristics and biases, explains Chris. Although they aren’t necessarily completely irrational, they are also not perfectly rational. It has been shown that the more you trade, the less successful your results are. The average trader underperforms the average mutual fund, and the average mutual fund underperforms the index.

So why would anyone want to be so active? Chris believes part of the advantage of private equity and a disciplined approach to pacing over vintage cycles is removing that subjectivity. When you do, you can avoid emotional factors like trying to time cycles and tactfully redeploy. As opposed to emotion — it focuses on factors and characteristics, statistics, and momentum.

Diversify your portfolio.

Make sure you don’t put all your eggs in one basket. Investing in a diversified portfolio will reduce your risk and increase your chances of financial success.

The private markets are where you want to be, Chris adds. Funds are the best way to do that, as it is extremely difficult to go direct and build a network overnight that takes years to develop. There are ways to co-invest with those funds over time and get closer to the assets. You can, however, benefit from funds specialists’ expertise in diversifying across a wide range of companies so that you have access to a diversified basket of funds.

“So, you get the power of diversification,” Chis says. “And now, you build a portfolio of funds; it’s actually less than 99% or higher than 99% probability of a positive return.” This strategy allows you to find very little risk to your capital when you combine five, six, or ten funds.

Monitor and rebalance

Keep a close eye on the performance of your alternative investments and portfolio as a whole. You may need to adjust your holdings as is necessary to maintain the risk level and asset allocation you desire.

Keep yourself updated

Keeping track of market trends, economic conditions, and regulatory changes could significantly impact your alternative investments. A well-informed investor can make better investment choices.

Invest for the long term

There is a risk of volatility with alternative investments in the short term. Long-term, however, they usually perform well. So, you will likely see positive returns if you are patient and stay invested.

In addition, alternative investments may have more extended lock-up periods, so you may be unable to access your funds immediately. Hold onto your investments for a long time to fully realize potential gains.

Featured Image Credit: Photo by Ron Lach; Pexels; Thank you!