Common Signs of Stability in Alternative Assets
With the market roller coaster ride that the COVID-19 pandemic ushered in, you could be forgiven for seeking solid ground. You know, reliable assets you can count on to deliver returns, even in market downturns.
And as an alternative investor, you’re in the right boat to invest for stability.
Here’s a look at when and why you need a stable alternative asset and how to identify one.
Investment Stability vs. Volatility
First, it’s important to understand the basics of stability and volatility and why they matter when choosing investments.
We often speak about market volatility, which is the frequency and magnitude of price movements. The bigger and more frequent the price movements, the more volatile the market. Conversely, a stable market is one where price fluctuations are few or smaller in size.
Assets work the same way.
In investing, volatility is a statistical measure of the dispersion of returns for a given security, typically measured as a standard deviation or variance between returns on the same security. In plain English, volatility measures how much an asset’s price swings around the mean, though it can also measure the statistical consistency of your returns. Greater dispersion means more volatility, and more volatility translates to a riskier asset.
Why Stability Matters
The inverse of volatility is stability. The more consistent an asset’s pricing and returns, the more stable it is. That means more than just peace of mind.
When we talk about stability in investment, we’re talking about how consistently you can rely on your asset to deliver returns. Volatile assets are considered risky assets because they don’t deliver returns as consistently as more stable assets. That means you may not be able to count on them for results.
While no investment is guaranteed to deliver, there is something to be said for having a high level of confidence that you’ll get results. In fact, stability becomes increasingly important as you reach the deadline of any financial goal. Investors have to increase their stability the closer they get to the deadline or they risk losing their investment without time to recuperate the loss.
When you save for retirement, for example, your investments get increasingly low-risk (and more stable) as you approach your retirement age. If you plan to retire at 70 and you’re currently 20, you have 50 years to recover a loss. But if you’re 60, you don’t have very much time left, and may not be able to afford to lose the gains you’ve already made.
Plus, stability is critical for building long-term wealth over time. Every portfolio requires some risk for growth, but it doesn’t do you much good if you lose everything when the market swings. A percentage of stable assets in your portfolio can insulate you against losses.
Tradeoffs of Stability
However, risk and return are highly correlated—two sides of the same coin. This is why investors are taught that you need to take bigger risks to see bigger returns.
Some of the most stable assets are the safest assets, but this also makes them the least profitable. Take bonds, for example. You more or less know what you’ll get back when the bond reaches maturity, barring a serious drop in bond prices. However, because the return is almost guaranteed, it isn’t in the bond issuer’s interest to hand over a huge return—otherwise, they lose too much money to sustain operations.
Basically, if you associate stability with safety, you should also associate extreme stability with lower returns. That isn’t to say that you should only reach for volatile assets. Quite the opposite. It’s to say that you need the right balance of stability, and you need to think about what you need that stability to achieve.
Are Alternative Assets More Stable?
This brings us to alternative investments.
One of the major benefits of alternative investments is their usefulness as a hedge—because alternative assets have low stock market correlation, they’re quite useful as a hedge against market volatility. This does not necessarily mean that an alternative asset is inherently more stable than a conventional one. It just means that the asset’s volatility drivers work differently.
Signs of Stability in an Alternative Investment
Like other assets, the stability of an alternative asset can be observed in its price fluctuations. You can calculate the stability of an alternative investment using the same calculations—namely, the variance and the standard deviation (the square root of the variance).
To do this, start by finding the mean of the data set (in this case, the previous prices) by adding each data point and dividing by the total number of data points. Next, calculate the difference between each value and the mean (this is calculating variance) by subtracting the mean from each data point. Negative numbers are allowed. You’ll probably have a lot of data points, so use a spreadsheet. You’ll then square the deviations, which eliminates any negative numbers. Finally, you’ll add the squared deviations together, divide by the total number of deviations, and take the square root of the resulting number.
This will give you the standard deviation you can expect from the price. The higher the standard deviation, the greater the price swings and the more volatile the asset.
The one challenge for an alternative asset is that price history is often difficult to acquire. If you wanted to calculate the variance and standard deviation on a piece of blue-chip art, for example, you would need the work’s complete transaction history and provenance, at which point you would have to work with a licensed dealer and an attorney to verify the piece’s paper trail.
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