Alternative Investments for Dummies

October 12, 2021

There’s a lot of buzz about alternative investments, but…what are they? And how do they work? Here’s a breakdown on alternative investments for dummies.

Once upon a time, alternative investments were the playground of the rich. They were the kind of investments that you picture when you imagine the Hollywood vision of investing—men in suits that cost more than your mortgage payment throwing around more money in a day than most people make in a lifetime.

These days, though, alternative investments are going mainstream, especially as the global alternative asset market recovers from the shock of 2020.

That’s good news for ordinary investors like you. Even if your name isn’t Bezos or Buffet, you can—and should—make use of alternative investments for your portfolio. And if you’re not sure where to get started, here’s a walkthrough of alternative investments for dummies.

What are Alternative Investments?

If the name makes alternative investments sound mysterious or vague, they’re not. In basic terms, an alternative investment is anything that doesn’t fit one of the three conventional investment categories:

  1. Stocks
  2. Bonds
  3. Cash

In other words, anything that isn’t stocks, bonds, or cash is technically an alternative investment. These can be financial assets or intangible assets.

The one thing all of them have in common (which is why they’re categorized as alternative investments) is that they’re not traded on structured public markets like Nasdaq or the Dow Jones (where stocks, bonds, and cash assets are traded). Instead, they are traded on alternative secondary markets (which aren’t markets so much as loose networks of like-minded investors) or traded privately between like-minded investors.

Examples of Alternative Investments

As you can guess, alternative investments are thus a huge category of investments and include things like:

  • Fine art
  • Hedge funds
  • Private debt
  • Distressed securities
  • Wine
  • Derivatives
  • Venture capital
  • Real estate
  • Commodities
  • Gold and other precious metals

If those things seem to have as much in common as a raven and a writing desk, keep in mind their primary uniting feature: they’re not traded on structured public markets.

There are a few reasons why alternatives aren’t traded on these markets—three specific reasons, which most alternative investments have in common:

  1. They’re complex
  2. They’re loosely regulated
  3. They’re illiquid (at least compared to conventional assets)

This is why alternatives were traditionally a rich kid playground. In the past, the high initial investment requirements, complexity, and limited regulation meant that the SEC only allowed accredited investors to access these investments. An accredited investor is a person allowed to participate in certain investments under federal securities law because they have sufficient resources and financial sophistication to fend for themselves without the protections of a registered offering.

These days, the SEC has broadened the definition of accredited investor to account for financial sophistication instead of just financial security, allowing people who don’t qualify for the term “high-net-worth” a means to participate in the market. After all, money doesn’t buy everything—investment brains, for instance.

And thanks to modern innovations like crowdfunding, ordinary investors now have more tools than ever to get started with alternatives.

Alternative Investments for Dummies

Which begs the question: what’s all the fuss for? Why buy alternatives when you could invest in stocks and bonds and get a simpler investment and SEC regulation to boot?

There are as many reasons for buying alternatives as there are investors to buy them, but the most common one is diversification.

One of the foremost benefits of alternative investments is that they have low (or no) correlation to the stock markets. If the stock market crumbles, it doesn’t necessarily mean your alternative investments will follow. It depends on the investment, of course, but the logic essentially runs that even if the rest of your portfolio takes a hit, alternatives should (hopefully) hold their value, or at least not fall as much.

The Risks of Alternative Investments

To be clear: that does not mean that your alternative investments will always hold value if the stock market dives. They may hold value, but it’s not guaranteed—which is true of any investment.

Alternative investments also come with their own unique complications, which are also the three features they have in common (less liquidity, less regulation, and more complexity).

At the center is complexity. For example, it’s simple enough to value an Apple stock—it’s based on market supply and demand. But how do you value a 1933 Saint-Gaudens Double Eagle $20 gold coin? What about Klimt’s Death and Life? Here’s a hint: you’ll have a hard time with the coin, since it was never officially released by the United States Mint and there are only 13 known to exist in the world as of 2018. As for the Klimt, well. You’re looking at a one-of-a-kind piece, and art is a giant consensus market.

In other words, alternative investments are complex because the items themselves may be difficult to value, and because transactions involving them are rare. Also, investors interested in those transactions are niche. Not all alternatives are like this—regular gold bullion or commercial real estate, for instance—but some are.

This is also why alternatives tend to be less liquid than conventional investments. In investing, liquidity is how quickly a security can be bought and sold. Basically, it’s how fast you can convert an asset into cash, the ultimate value store. And because such transactions are rarer than stock sales and come with unique complications not seen in stocks, it’s harder for the SEC to regulate them.

On the other hand, the risk of alternatives can also come with greater reward. Take blue-chip art, for example, outperformed the S&P 500 by 180% from 2000 to 2018. And either way, alternatives have limited stock market correlation, which makes them a useful inflation hedge and rescue asset.

Ready to Get Started in Alternative Investments?

The verdict on alternative investments for dummies? They can be a great addition to your portfolio, as long as you do your homework and learn the ropes.

Here at Masterworks, we’re on a mission to democratize alternative investing—particularly the world of blue-chip art investing. We collaborate with Citi Bank and Bank of America to identify high-growth artist markets with the best potential risk-adjusted returns, then take care of the authentication and purchase and file with the SEC so that investors have protection. Then, members can purchase shares in multi-million-dollar art for as little as $20 per share, and you collect dividends when we sell the art. Ready to put alternatives to work for your portfolio? Fill out your membership application today to learn more.

Masterworks is a fintech company democratizing the art market. Our investors are able to fractionally invest in $1mn+ works of art by some of the world's most famous and sought-after artists.