Alternative investments are a diverse group of investment vehicles that include commodities, derivatives, and riskier investments. What classifies these instruments as “alternative” is that they fall outside the traditional world of long-only stocks and bonds. While often perceived as inherently only riskier investments, there are elements of alternative investments that are every bit as stable as other asset classes.
Investments in commodities can range from precious metals, or hard commodities, to agricultural products, or soft commodities. Because commodities are most often traded as futures contracts, or some other form of derivatives, there is a high degree of leverage involved. Leverage, not inherent instability, is one of the reasons that commodities are considered one of the riskier investments. Overall, commodities are an appropriate allocation for most portfolios.
Derivatives are investment instruments which are derived from other instruments. For example, options are derivatives of stocks and futures because the value of the option is based on changes in the price of the underlying stock or futures contract. Some of the most common derivatives include:
- Stock options
- Futures options
- Credit Default Swaps (CDS)
The last element on the list of derivatives is one of the reasons that it is commonly believed that derivatives are one of the riskier investments. In the housing collapse, problems in the market were exacerbated by investors who had made large bets in derivatives. In reality, derivatives are only as risky as one allows them to become; careful risk management ensures that derivatives need not be riskier investments than more traditional choices.
The reality is that alternative assets are not riskier investments unless they are handled carelessly. As with any investment, they should be understood by the investor before any capital is allocated. While it is possible for some alternatives to be more complex, this alone should not classify them as riskier investments. Conduct careful research and exercising good judgment can make an allocation to alternative investments an important part of any portfolio.