Traditional Vs. Alternative Investments- Understanding The Risks

When it comes to investing your hard-earned money, there are many available options. The possibilities seem endless, from stocks and bonds to real estate and commodities. But what about alternative investments? Are they worth considering?

Let us deep dive and understand the advantages and risks associated with alternative investments compared to traditional investments and how they can help in creating an inflation-beating portfolio.

What Are Traditional Investments?

Traditional investments refer to investing in prominent and conventional assets such as stocks, gold and real estate.

Types Of Traditional Investment

Some different types of traditional investments are as follows:

1. Stocks

When you invest in stocks, you are buying shares of companies listed on the stock exchange. Each share of a company represents a portion of its ownership. So, if you purchase ten shares, you become the owner of 10 units of the business. 

2. Bonds

A company or government issues bonds when it wants to raise money through debt. In this case, the investor is not getting ownership of the entity. The investor simply becomes a creditor to the firm. Returns on bonds are less than that on stocks. However, they are safer than stocks because when a company shuts, it is legally bound to pay off its debts. Bonds are paid off before equity.

3. Cash Equivalents

Cash equivalents refer to all the instruments which are easily convertible into cash (gold, fixed deposits, recurring deposits, etc.). These are the safest and the most convenient means of deposit.

What Are Alternative Investments?

You can think of alternative investments as the rebels of the investment world. They go beyond the usual investment avenues like stocks, mutual funds, fixed deposits, and gold. Alternative investments encompass many assets, including private equity, hedge funds, real estate, securitised debt instruments, venture capital, art, collectibles, etc.

Alternative investments break the traditional mould and offer investors a different path to diversification and potentially higher returns. Alternative investments encompass a wide range of assets and strategies that are less conventional and often operate outside the public markets. Here is what you need to know about alternative investments:

1. Direct Ownership And Private Investments: Alternative investments like private equity, hedge funds, real estate, and venture capital often involve direct ownership of physical assets or investments in private companies. This direct ownership or involvement in private enterprises sets them apart from publicly traded stocks and bonds.
2. Lower Liquidity: Alternative investments typically have lower liquidity than traditional investments. While stocks, bonds, mutual funds and commodities are easily tradeable, alternative investments often have longer lock-up periods. This means that once you invest in alternative assets, it may be more challenging to sell or exit your position quickly. Investors should be prepared for potential limitations on liquidity when considering alternative investments.
3. Complex Regulations And Structures: Alternative investments can be subject to more complex regulations and structures than traditional investments. For example, private equity investments may involve limited partnerships or other legal structures that require careful consideration. Additionally, alternative investments may have unique tax implications and reporting requirements. It is essential to thoroughly understand these complexities before investing in alternative assets.

Are Alternative Investments Safe?

Alternative investments are considered safer than market-linked options like stocks and mutual funds but riskier than India’s preferred investment tools like gold and fixed deposits.

Types Of Alternative Investments

1. Cryptocurrencies

Cryptocurrency is a type of digital or virtual money that is hard to counterfeit because it is secured by cryptography. It uses blockchain technology, which is decentralised, to facilitate safe peer-to-peer transactions without the use of middlemen like banks. Because of their inherent volatility and potential for large returns, cryptocurrencies like Bitcoin and Ethereum are regarded as alternative investments. Diversification, innovation, and the chance to be involved in the developing digital economy are what draw investors to them.

2. Real Estate

You may invest in personal or commercial real estate. The notion is that this requires a lot of money. Although this is completely true for personal real estate, it might not be very true for commercial real estate. Now, you can invest in commercial properties like hotels, malls, and office spaces without having crores in bank; through an instrument called REITS. Real estate investment trusts REITS work like mutual funds. REITS create a pool of small savings and invest them into properties. The rent derived is distributed among unit holders or investors.  

3. Private Equity

Startups can raise funds privately through investors. Private investors can come in at various rounds of investments. A private investor makes money only when the company’s valuation increases in the next round or through an IPO.

4. Hedge Funds

Hedge funds work primarily like mutual funds, but their strategies are much more extensive. It usually requires a very high initial investment and is actively managed.

5. SDIs

Securitised Debt Instruments (SDIs) are financial securities formed by securitising individual debts, a process where assets are transformed into securities backed by those debts. These assets can include a variety of loans, including equipment leases, auto loans, and home equity loans. Through this securitisation process, SDI owners receive income from these mortgages and underlying assets. 

Differences Between Traditional Investment And Alternative Investment Options

Let us understand the differences between traditional vs alternative investment.

Risks Associated With Traditional Investment

In the case of traditional investments, the risk factor varies with instruments. Instruments like fixed deposits, recurring deposits and gold are the safest investments. Equity instruments such as stocks are subject to market volatility and are riskier 

In the case of investments like stocks and bonds, they are much safer than traditional forms of investments. Their low-risk metric is due to the following reasons:

1. There are numerous laws safeguarding investors.
2. Traditional investments are aimed towards middle to low-income households. So, they are not used for very risky avenues.

The Risk Associated With Alternative Investment

Alternative investments have the higher risk value comparatively due to the following reasons:

1. These investments usually require a very high initial investment.
2. There is a lack of government support for some alternative investments.
3. These instruments push investor money into comparatively riskier avenues.

For example, in the case of private equity, the stage in which private investors put in money is usually the ideal stage or when the company is making a loss since it is just starting. There is a lack of historical records to gauge the company’s future performance and so on.

Mitigate The Risk With Diversification

• It is important to understand that alternate investments are riskier because they offer way more returns than traditional investments.
• The investor should aim for the optimum balance between risk and return, i.e., traditional vs alternative investments so that he or she can get the maximum return at the minimum possible risk.

Factors Influencing The Mix Of Traditional Investments And Alternate Investments

Rather than getting into alternative investments vs traditional investments, let us understand some factors which should be considered to make a balanced portfolio.

1. Available first

The most important criterion is how much money you have for investing. If you fall under a very high-income bracket, you can lean more towards alternate sources of investment.

1. Age

Yes, your age does determine your risk appetite. Conventionally, the higher your age, the lower your risk appetite. Hence, limited presence of alternative investments in your portfolio.

1. Nationality

Which country you belong to determines which laws your investment will fall under. If your country upholds alternative investment, it will secure your investment in them.

Checklist For Evaluating Alternative Investments

Now, let us talk about how you should evaluate alternative investments before committing your money

1. Assess the risk and return potential of the investment. It is crucial to understand the upside potential as well as the downside risks. Look at historical performance and projections to get a clear picture.
2. Do not forget to evaluate the issuer's expertise and financial track record. As a business entity, their model should be scalable and profitable. As management, they should possess the skills and experience necessary to navigate the alternative investment landscape successfully.
3. Transparency and due diligence are the keys. Dig deep into the investment's financial statements, legal documentation, and underlying assets. The more you know, the better equipped you will be to make an informed decision.
4. Consider the liquidity and exit strategy of the alternative investment. Unlike stocks, alternative investments often have longer lock-up periods and limited exit options. Ensure you are comfortable with the time frame and understand the potential constraints.
5. Take a close look at the fee structure associated with the investment. High management fees, performance fees, and other expenses can eat into your returns. You want to ensure that the fees are fair and aligned with the value provided.

Conclusion

Alternative investments can bring advantages to your investment portfolio beyond the traditional options. They allow diversification, which helps reduce your overall risk, especially when the equity market is going through a rollercoaster. However, no asset class is 100% risk-free, including the alternative investments. Understanding the risk factors and taking preventive measures is necessary to reap the benefits.

Since research and due diligence at the individual level may get overwhelming and time-consuming, online discovery platforms like Grip Invest bring detailed coverage of risks involved with various alternative investment assets. Explore Grip Invest to research SEBI-regulated, credit-rated and curated alternative investments.

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