What are the Limitations of Alternative Investments?

October 12, 2021

Like any investment, there are a few limitations of alternative investments that you need to know. But if you know them, you can mitigate them. Here’s what investors should know.

There’s a whole wide world of investing out there, and it goes well beyond stocks. In fact, if you’re trying to craft a well-balanced portfolio, you need to look beyond the stock market to balance your risk and volatility. That’s where alternative investments come in—after all, they have very low correlation with the stock market, which means they’re strong insulation against stock market volatility.

Of course, like any investment, alternative investments are not without limitations. That doesn’t mean you shouldn’t invest in them. It just means you have to know what you’re doing. Here’s a look at the limitations of alternative investments and what you can do to mitigate them.

What are Alternative Investments?

Alternative investments are any investment asset that doesn’t fall into one of the three conventional investment categories:

  1. Stocks
  2. Bonds
  3. Cash

Of course, for those who are paying attention, you’ll notice that the three conventional categories are three highly specific assets. This means that alternative investment covers an extremely broad range of assets from private equity to Thomas Jefferson’s wine bottle (okay, that one got a bit hairy, but an extremely old and valuable wine bottle can still be a commodity investment).

Types of alternative investments include:

  • Private equity
  • Private debt
  • Blue-chip art
  • Investment real estate
  • Hedge funds
  • Oil
  • Natural gas
  • Structured products
  • Managed futures
  • Derivatives contracts
  • Life insurance
  • Venture capital

A good way to think about alternative investments is to break them into financial assets, like venture capital, private debt, or hedge funds, and tangible assets. You can also classify assets based on relative risk (compared to other alternative investments).

You can also refer to this periodic table of alternative investing and compare with this periodic table of asset classes.

The Limitations of Alternative Investments (and How to Make the Most of Them)

The investment strategy varies widely depending on the asset in question. However, investment vehicles lumped under the category of alternative investments typically have a few features (and a few downsides) in common.

Fortunately, if you know what these shortfalls are, you can find ways to counterbalance them.

They’re Usually Illiquid

In investing, liquidity refers to how quickly or easily a security can be bought and sold in a secondary market. When we talk about a stock’s liquidity, we’re referring to how rapidly shares can be bought and sold without a substantial impact on share prices. The more liquid a security is, the easier or faster (or both) that it is to sell it. Think of a sale like pouring liquid from a bottle. The more liquid it is, the easier it is to get it out of the bottle.

This is one area where alternative investments significantly diverge from conventional investments. As a rule, most alternative investments are fairly illiquid, especially in comparison to their conventional counterparts.

There are a few reasons for this. For one, it’s much easier to find a buyer interested in Apple stock than a racehorse. The market for buyers is inherently smaller, which means you have to put more work into selling an asset.

For another, many alternative investments are trickier to value than their conventional counterparts. Some assets are hard to value at all, never mind selling them, since the transactions attached to such assets are rarer and can be subjective. For example, if you have the only copy of a Dali painting that exists in the world, how do you value it? What measuring stick do you even use?

On the flipside, lack of liquidity also means that a small number of market participants have a much greater influence on an asset’s value. Either way, you should plan on holding onto these assets for a while and plan ahead for selling them.

Market Inefficiencies

In economic theory, an inefficient market is one in which an asset’s price is not an accurate reflection of its value. In plain English, inefficiency in the market means that not all of the available information about an asset is incorporated into its valuation, which means that its price isn’t an accurate reflection of what it’s really worth.

You can probably guess why that’s a concern with alternative investments.

As a rule, alternative investments have fewer opportunities to publish verifiable data with which to value an asset. For example, if you’re selling a 1933 Saint-Gaudens Double Eagle $20 gold coin, it’s highly likely that you can’t incorporate all the relevant information to assess its value. After all, it’s one of only 13 known coins like it in the entire world.

Again, you have to know going in that you’re going to have a harder time valuing your alternative investments. That means you need experts on your side. Otherwise, you’re going to fight an uphill battle when you decide to sell.

They’re Complex

In case you hadn’t caught on yet, alternative investments are…complex.

Not everyone knows the ins and outs of stocks, but most people know what they are conceptually. And once you do a little reading, they’re fairly straightforward to understand. But alternative investments by definition are not stocks, and they carry far more complexity baked into the deal.

This means that the onus is on the investor to do their due diligence. And if you’re not an expert yourself, you need to pay experts to help you navigate the process. Otherwise, you’ll find yourself making bad investments.

Find Your Footing with Alternative Investments

As with any form of investment, your best bet to counteract the limitations of alternative investments is to craft a well-balanced portfolio. We’re here to help you take advantage of alternative investments as your blue-chip art experts and your window into the exciting world of blue-chip art as an investment asset.

We handle all the research for you in partnership with Citi Bank and Bank of America. We also handle the auction process (and file an SEC offering circular for every painting available for our members to buy shares). That’s a lot of art, considering that we make $1 million to $30 million in paintings available every 10 days. So if you’re ready to branch into an exciting alternative investment asset class with the experts on your side, 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.