What are the Risks of Alternative Investments?
Like stocks and bonds, alternative investments come with unique risks. Here are some risks to keep in mind when it comes to alternative investments.
There’s more to investing than just stocks and bonds. In fact, there’s a whole alternative market out there, and it’s thriving. According to Preqin, the overall market for alternative investments could grow to $14 trillion by 2023.
Better still, thanks to advances in technology and investing, alternative investments aren’t just for the rich anymore.
However, because alternative investments are quite different from conventional investments, they carry their own unique risks. Here are some alternative investment risks that investors need to know before joining the market.
What are Alternative Investments?
An alternative investment is basically any investment that doesn’t fit the three conventional categories:
Because alternative investments aren’t stocks, bonds, or cash, they’re not traded on primary markets like the stock exchange. Instead, they travel through smaller niche markets. As you can guess, because alternative investments are quite broad, they include a huge variety of investments, including:
- Fine art
- Real estate
- High-end wine
- Private debt
- Private equity
- Hedge funds
- Venture capital
- Peer-to-peer lending
- Distressed securities
- Derivatives contracts
- Managed futures
Traditionally, alternative investments were the playground of the rich (more specifically, high-net-worth individuals and institutional investors like university endowments). It wasn’t just a question of taste.
For one thing, high-net-worth individuals and institutional investors used to be the only ones who were allowed to participate in certain investments under federal securities laws. They were the only ones who qualified as accredited investors, which is basically an investor with the financial sophistication and resources to 1) know what they’re getting into, and 2) have the resources to buy in without becoming destitute if the investment failed.
The SEC recently modernized the accredited investor definition to pay more credence to financial sophistication instead of just wealth (after all, wealth doesn’t buy investment knowledge). Still, it wasn’t until recently that new models like crowdfunding made it possible for regular investors to participate in alternatives from an initial investment perspective.
Unique Features of Alternative Investments
In order to understand the unique risks of alternative investments, it helps to know the unique features alternative investments have in common. You might not think an 80-year-old bottle of wine would have anything in common with private debt, but all alternative investments typically have four features in common:
- They’re more complex than conventional investments
- They’re less regulated than conventional investments
- They require higher initial investments to get started
- They’re fairly illiquid compared to conventional investments
As it happens, these common features are directly related to the risks of alternative investments.
Alternative Investment Risks
In simple terms, the risks of alternative investments boil down to the fact that they’re nothing like stocks and bonds. Because they don’t behave like stocks and bonds, and because they’re not traded on primary markets, this introduces unique risks into the equation.
First, because alternative investments don’t travel on the stock market, they rely on secondary markets. Second, because there’s a much smaller market of interested investors, these markets are niche-specific.
Take the art market, for example. You can find someone to buy Silicon Valley stock almost anytime you want, but finding a buyer for a Magritte painting is a whole different story. Plus, the art market has historically functioned on opacity and personal relationships.
In a gallery, for example, a gallerist won’t necessarily sell to anyone who walks in their door. They want to keep a stable of high-value clients happy, especially if those clients are also big-name collectors who can drive up the value of artists in the gallerist’s stable. Because of this, gallerists (and curators, and collectors, etc. etc.) frequently trade on market-moving information for profit, like telling a collector about a major museum show coming up in a few years so they can snatch up an artist’s work before it appreciates.
Limited Market Data and Transparency
These niche markets add further risk because the assets within them have far less price transparency than stocks. As a rule, they publish far less verifiable performance data than conventional assets, and depending on the asset, it may be difficult to value it in the first place.
Take art pricing, for example. The most important factors in a work’s price are:
- The relative fame of the artist who made it
- The artist’s standing in the global or regional market where the work will sell
However, there are a lot of complications attached, even in ways you wouldn’t expect. The size of the work, for example, increases the price up to a point, but only the point at which the work becomes impractical for private buyers to purchase. The provenance and exhibition history also significantly impact the value—basically, if the work was displayed in important places and traded among major collectors, it drives up the value for the next buyer.
That said, art pricing is also subject to invisible forces that may not become apparent until they’ve already swayed the art’s value. Basically, the number of artworks that cannot, have not, or will not come to market may nevertheless pull prices on works that do. Museum accessions are the best example of this—they’re basically the black holes of the art world into which masterpieces vanish never to hit the market again, but because they’ll never hit the market again, they artificially underwrite scarcity and demand.
For these reasons, alternative investments tend to be illiquid, especially in comparison to conventional assets.
Because they operate on niche markets, achieving liquidity is often the art of finding the right expert partner and the right buyer. This is especially important in art, for example, where high-value art sales often require lengthy negotiations to get off the ground—like having the professional connections to convince a gallerist or auction house to sell a piece, especially if they’ve already sold it once.
Overcoming Risk and Putting Alternative Investments to Work
As with any investment, the key to overcoming alternative investment risks is to understand what you’re getting into, do your homework, and find the right professional to help you.
That’s where we come in. At Masterworks, we’re democratizing blue-chip art investing by serving as your expert partner in the art world. Our industry-leading research team collaborates with CitiBank and Bank of America to identify high-growth artist markets with the best potential risk-adjusted returns. After we navigate authentication and purchase and file with the SEC, members can purchase shares in multi-million-dollar artworks starting at just $20 per share. Then, when we sell the art, you collect your gains. Ready to put alternative investments to work for your portfolio? Fill out your membership application today to learn how blue-chip art fits into your investment strategy.