investing

Pros and cons: Alternative investments

Professors' Profiles

Jill Foote, CFA, Ph.D.


Title:
Senior lecturer in finance

School:

Steven Dolvin, CFA, Ph.D.

Title:
Associate professor of finance

School:

Todd Feldman, Ph.D.

Title:
Associate professor of finance

School:

What role should alternative investments play in an individual investor's portfolio, and what are the pros and cons?

Jill Foote, CFA, Ph.D.

AnswerAlternative investments (e.g., real estate, hedge funds and private equity) can play an important -- albeit usually small -- role in an individual's portfolio.

The main pro associated with alternative assets is they tend to be less correlated with other markets and thus, provide diversification to a portfolio. The cons are that they are less liquid (harder to sell if an investor needs the money back) and can have lengthy down cycles (such as residential housing). Additionally, many alternative asset classes are limited by regulation to sophisticated "accredited investors."

Most individuals would be well advised to avoid speculating in these markets or buying undiversified exposure. Thus, if alternative assets are desired, generally an investor should seek a mutual fund or hedge fund manager with a long track record and stellar reputation.

Steven Dolvin, CFA, Ph.D.

AnswerFor smaller investors, they may be irrelevant. For those with a sizable portfolio, alternative investments should play a role. These would include private equity, hedge funds, real estate, commodities, etc. The benefit is not really an extremely high return, but rather an element of diversification.

Todd Feldman, Ph.D.

AnswerAlternative investments should play a role in an investor's portfolio because it does provide diversification. However, an investor should never allocate too much to alternative investments. Only 5 percent to 15 percent should be allocated. The con is that alternative investments can be volatile, creating greater risk for an investor's portfolio. This is why an investor should only allocate a small percentage to alternative investments. The small percentage provides just enough to receive the benefit of diversification and reduce the risk of the overall portfolio. If an investor allocates too much, then (he or she) may increase the risk of the portfolio.

 

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