To reduce risks within an investment portfolio, diversification is essential. The concept is simple: if one investment performs poorly, it can be balanced out by another that performs better. As a result, overall returns tend to remain more consistent.
Many professionals agree that while diversification does not guarantee immunity from losses, it is one of the most important components for achieving long-term financial goals. And, most importantly, for minimizing risk. Essentially, proactively balancing a portfolio across various types of investments lies at the heart of diversification.
Therefore, rather than putting all your hopes into a single company, it’s wiser to distribute your money across several investment areas.
What Is Portfolio Diversification?
The U.S. Securities and Exchange Commission (SEC) emphasizes several key aspects of diversification. First, make sure to allocate your money across different industries. This helps prevent total loss if one particular sector experiences a downturn.
Second, don’t hesitate to invest in multiple companies even within the same industry. Risks do not always impact an entire industry equally some companies may struggle while others thrive.
Next, consider diversifying across different asset classes. Each asset class performs differently depending on macroeconomic conditions. For example, rising interest rates tend to push bond prices down.
Therefore, investors often choose to divide their portfolios into several asset classes to protect themselves from broader financial risks.
Types of Alternative Investments
In general, when people talk about assets, they usually refer to stocks, bonds, and cash. However, that’s only part of the picture there are other types of investments beyond traditional categories, often referred to as alternative investments or alternative assets.
This category encompasses a wide range of investments with unique characteristics. While diverse in nature, most alternative investments share several common traits:
- They are less strictly regulated by the U.S. Securities and Exchange Commission.
- They tend to be illiquid, meaning they cannot be easily sold or converted into cash.
- They have a low correlation with traditional asset classes, meaning their movements don’t always align with the broader market trends.
Here are some common types of alternative investments:
Private Equity
Private equity refers to capital investments made in private companies. This broad category includes venture capital, growth capital, and buyouts.
One of the most important aspects of private equity is the relationship between the investor and the company receiving the funds. These investors often provide added value such as industry expertise, talent acquisition support, and mentorship for founders.
Private Debt
Private debt refers to lending or credit investments that are not financed by banks or traded on public markets. The term “private” refers to the investment instruments themselves.
Private debt is often utilized when companies need additional capital to grow their business. Companies issue what’s known as private debt funds, which typically generate returns through interest payments and loan repayments.
Hedge Funds
This are investment pools that trade relatively liquid assets and employ a variety of strategies aimed at generating high returns. Hedge fund managers may specialize in strategies such as long-short equity, market neutrality, arbitrage, volatility, and quantitative investing.
Key Risks of Alternative Investments
Alternative investments may offer diversification and the potential for higher returns, but they also come with specific risks.
The primary one is illiquidity. Many alternative investments cannot be easily sold, meaning investors may need to wait a long time to access their funds when needed.
Another concern is limited transparency and regulation. In practice, alternative investments often face less regulatory oversight and are not subject to the same reporting requirements as traditional investments. This can make valuation more difficult and may lead to information asymmetry.
Additionally, because each alternative investment instrument differs, the associated risks also vary. For instance, geopolitical events or weather conditions can significantly impact commodity investments. Allocating a large portion of a portfolio to a single alternative asset can lead to concentration risk, resulting in higher volatility and potential losses.
