Are Alternative Investments Risky?

October 12, 2021

Are alternative investments risky? Yes—like any other investment. Here’s a look at the unique risks investors need to know.

Once upon a time, alternative investments were the playground of the ultra-rich. These days, though, a whole new world of investments is available to ordinary investors like you.

Alternative investments are not suited to everyone—no investment is. Are alternative investments risky? Yes, but that doesn’t mean you shouldn’t invest in them. Alternative investments require a level of knowledge and sophistication from the investor to know what they’re getting into.

Here’s a look at what contributes to the risk of alternative investments, why the risk is different from conventional investments, and what you need to know to make informed decisions.

What are Alternative Investments?

Alternative investments are a broad category covering any investment that doesn’t fall into one of the three conventional investment categories:

  1. Stocks
  2. Bonds
  3. Cash

In other words, alternative investments are pretty much anything that isn’t stocks, bonds, or cash. This includes things like:

  • Fine art
  • Hedge funds
  • Private equity
  • Private debt
  • Derivatives contracts
  • Managed futures
  • Structured products
  • Cryptocurrency
  • Real estate
  • REITs
  • High-end wine
  • Classic cars
  • Gold
  • Venture capital

As you can see, these are wildly diverse items, each with its own particular market. Some of them, like hedge funds, are only open to accredited investors, meaning individuals who qualify under federal securities laws to participate in certain offerings. This typically meant institutional investors or accredited, high-net-worth individuals (someone with $1 million to $5 million in liquid assets).

These days, though, alternative investments are opening up to more investors. The SEC updated its definition of accredited investor in 2020 to reflect not just wealth, but also greater financial knowledge. After all, wealth confers the ability to withstand losses, not the financial sense to make gains.

The Risks of Alternative Investments

That said, there are certain risks attached to alternative investments, which is why the investor pool has traditionally been small and limited to the qualified. There are three specific risks worth noting:

  1. Less regulation
  2. Less liquidity
  3. Greater complexity

These are not reasons why you should avoid alternative investments, but rather features of alternative investments that you need to be aware of before you get started. Otherwise, you won’t have the first clue what you’re getting into—and you won’t be able to make educated decisions about the risks you’re comfortable taking.

Less Regulation

Part of the reason why alternative investments are constrained to accredited investors is because they’re less regulated than their conventional counterparts. On one hand, this means that alternative investments (and alternative investors) have greater freedom in what they can do in the market. On the other hand, it also means that investors have less protection than they would with regulated conventional investments.

Alternative investments fall under the purview of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed in response to the 2008 financial crisis. It contains about 2,300 pages of provisions, all targeted at sectors believed to be responsible for the 2008 crisis.

In addition, alternative investments are technically subject to examination by the SEC. Hedge funds, for example, have practices that are subject to periodic SEC review. Here’s the catch: hedge funds are not legally required to register with the SEC if their assets under management are less than $100 million, or less than $150 million if the assets are entirely derived from accredited private investors.

The long and the short of it (see what we did there?) is this: when you branch into alternative investments, investors are responsible for doing their due diligence.

Less Liquidity

Another facet of the challenge is that alternative assets are less liquid than their conventional counterparts. In investing, liquidity refers to how quickly a security can be bought or sold in a secondary market—in other words, how quickly it can be liquidated into cash.

Alternative investments are less liquid than their conventional cousins for two reasons. First, the market for them is much smaller. You can sell an Apple stock pretty much any time you feel like it but finding a buyer for Magritte’s apple-faced The Son of Man is a whole different matter.

Second, it’s often difficult to sell alternative investments because it’s hard to value them in the first place. For example, how do you value a piece of fine art? You can value it based on technical aspects of the work, such as:

  • Artist
  • Title
  • Date
  • Provenance
  • Dimensions
  • Medium

But in the end, art is worth what a buyer is willing to pay for it. Just look at the two sides of the argument over Grimes’ NFT art—on one hand, you have a fan willing to pay almost $389,000 for a one-of-a-kind video called “Death of the Old”, and on the other hand, you have art world aficionados sniffing that it’s absurd to pay for a piece of digital art you could view online for free.

In some cases, you may not even have anything to value the item against. You’d have a pretty hard time valuing a 1933 Saint-Gaudens Double Eagle $20 gold coin—as of 2018, there are only 13 in existence.

Greater Complexity

This leads into the last point: at the end of the day, alternative investments are way more complex than their conventional counterparts.

There are several reasons for this. Take a hedge fund, for example. While it uses the same basic model as a mutual fund (pooling investor funds to earn money via the invested pool), it’s a far more complex investment vehicle than a mutual fund because it has much greater leeway to use investment techniques that are closed to mutual funds. Hedge funds are able to do that because they’re less regulated, but that also means they’re harder to navigate.

In addition, many alternative investments don’t have opportunities to publish verifiable performance data for investors, either because the data doesn’t exist or because it’s not obligatory to publish it.

Again, the onus is on the investor to know what they’re signing up for, to find the right experts, and to make educated decisions for their own long-term wealth.

Make the Most of Your Alternative Investments

Are alternative investments risky? Yes, but so is any investment. The key is understanding your own risk tolerance, understanding what you’re getting into, and making the right judgment call.

At Masterworks, we’re here to open up the world of fine art investing to everyday investors. Think of us as your market experts—our expert research team collaborates with CitiBank and Bank of America to identify artist markets with the best potential risk-adjusted returns. Then, we purchase the artwork and make shares available for investors to purchase. When we sell the painting, you collect your dividends. Ready to make your money work for you? Fill out your membership application today.

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.