Investment
Traditional Investments and Alternative Investments: The Question of Diversification
Throughout history, one thing has remained constant – the desire to accumulate or accrue wealth. With resources remaining ever-limited, human needs have not dwindled. Rather, they continue to grow. Since the industrial age, the rate of human technological innovation has been matched only by live birth rates. Interestingly, such is the extent to which inventions are evolving today.
Many of these innovations have improved global living standards. However, such increased standards have come with even more costs. Given the burgeoning human population, the planet’s resources are stretched thin. There’s hardly enough for the masses to sort out basic needs, much less invest.
Amid the uncertainty of the present time, a fraction of the older population continues to rack up wealth in the time-honed art of traditional investments. How can young people learn from this trend? Plus, how do these traditional investments compare to the more modern, alternative channels? We answer these questions and more in this article. Read on!
What are Traditional Investments?
In finance, traditional investments refer to investments channeled at well-known asset classes like fiat, bonds, and stocks. Unlike some alternative forms of investment, traditional investments are well-protected. The rules regarding risk management, liquidity, transparency, and diversification are clearly defined to the investors.Additionally, they have clearly identifiable, systematically-ranked risk categories; as such, investors do not go in blind.
Types of Traditional Investments
The most well-known traditional investments are:- Bonds
- Stocks
- Cash
- Equity shares
Bonds
Simply put, a bond is a debt security. Everyone borrows money in some way. Whether you’re using a credit card, mortgaging your house, or taking a small loan from a friend, it all amounts to the same thing. Similarly, big organizations and national governments borrow money too! How do they do it, you might ask? By issuing bonds.By buying a bond, you’re lending money to the bond issuer. In exchange, you get returns based on specified rates that last throughout the bond’s lifetime. Additionally, you get your principal or par value of the bond upon its maturity.
Since the dot-com bubble, bonds have done quite well, delivering annual returns of 6.74% to investors, only outperformed by stocks.
Stocks
Stocks are the most well-known type of traditional investment. In a nutshell, stocks are a certificate of company ownership. When you invest in stocks, you purchase ownership shares in a public company. By doing so, you invest in the company’s economic potential for growth over time. Companies like Netflix, Amazon, Domino’s Pizza, Apple, and Tesla are all organizations whose stock values have risen tremendously over the past few years.Cash
Cash investments are short-term obligations that provide interest returns to investors. Although the ROI is quite low compared to other traditional investment forms, the risk is equally low. Some common types of cash investments include the following:- Savings accounts
- Money markets, e.g., Treasury bills
- CD (Certificate of Deposit)
Equity Shares
Equity shares, also known as ordinary shares, are somewhat similar to stocks, as they represent company ownership. However, equity shares involve fractional ownership, with investors bearing equally reduced company liability. Shareholders have the right to vote in their respective organizations on various financial-related affairs.Traditional Investments: A Choice for the Young or Old?
Today, traditional investments are increasingly seen as the domain of millennials and older people. Per a study by the Bank of America Private Bank, about 75% of young investors aged 21-42 aren’t particularly reliant on significant returns from traditional stocks and bonds.It appears that young people, especially those in the Generation Z category, prefer alternative investment forms, such as real estate, private equity, and hedge funds. Given the recent underwhelming performance of the stock markets, the trend is hardly surprising. In fact, experts at Morgan Stanley are predicting that the Standard & Poor Index will plunge by about 20% in the next four months.
Still, traditional investments continue to be the top choice for the older generation, many of whom are skeptical about modern forms of investment, especially cryptocurrency. For instance, top investors, like Warren Buffett, have been critical of cryptocurrency in the past and continue to show aversion to the asset class.
Nevertheless, other alternative forms of investment remain popular with the older generation, especially hedge funds. Today, young investors are more open to alternative forms of investment. However, can this be interpreted to mean that traditional investment forms are dying slowly?
The answer is no! Traditional investments will continue to remain popular. However, savvy investors looking to diversify their portfolios have plenty of reasons to look for alternatives.
The Need to Diversify
Before the present, alternative investments were seen as “risky.” Bonds and stocks were the norm, and it was rare for serious investors to diversify into other channels. However, nowadays, the opposite is the case. Although the popularity of traditional investment vehicles is hardly dwindling, alternative investment forms are gradually coming up.High-net-worth and institutional investors are taking the lead, as they have realized that there is more value to enjoy in diversification. To further illustrate this, let’s quickly take a look at the example of retirement accounts
Retirement accounts are one of the most common forms of investment. They’re usually set up with one’s employer, who turns over the account’s control to a custodian for fund allocation based on income, retirement objectives, and age. This implies that retirement funds are passively managed. All the investor does is set it up while the custodian manages the funds.
Upon closer examination, one will find that most custodians prefer investing funds in traditional assets like mutual funds, bonds and stocks. This means that a typical retirement fund is vulnerable to the same volatility inherent in the stock market. In a nutshell, investors looking to diversify from the traditional forms of investment will hardly find retirement funds a reliable alternative.
Types of Alternative Investments
Let’s take a closer look at some of the most popular kinds of alternative investments today:Real Estate
Some experts argue that real estate investment belongs in its own category. However, for the purpose of this article, we’ll include it in this section as a form of alternative investment. For many years, real estate has been regarded as a quality investment.
Before the global recession of 2008, historical figures regarding housing pointed to a very positive future for the industry. Even after this global financial crisis, home prices continued to surge, only dropping slightly during the global pandemic.
Investing in rental properties allows you to be a landlord, responsible for property maintenance, managing tenants, and paying mortgage and property taxes. Return on investment in real estate takes one of two forms:
- Rent
- Land/Property appreciation
Hedge Funds
Hedge funds are an alternative investment where capital is pooled from various institutional investors or individuals to invest in various assets. As an investment vehicle, hedge funds can be linked to any other form of investment, making them one of the most ideal ways to diversify portfolios.For instance, a hedge fund may be actively involved in foreign exchange or real estate. This is where it differs from mutual funds, which are joint investment schemes where funds are channeled at single asset classes like bonds or stocks. To manage risk and build their portfolio, hedge funds employ various techniques. Hedge funds seek to maximize ROI and reduce risk in all market conditions, whether bearish or bullish.
Today, there are several hedge funds in the USA and around the world, including big names like Coatue Capital, Bridgewater Associates, Elliot Management, and Renaissance Technologies.
Commodities
This investment involves natural resource items like coffee, rice, corn, cocoa, grain, and oil. Additionally, it includes physical raw items like precious metals, e.g., gold.To invest in commodities, you’ll have to delve into the futures market via futures contracts or ETPs (exchange-traded products) that track a commodity index such as the S&P GSCI Index.
Although the commodities market is highly volatile and complex, investment returns can be very high. Alternatively, you can indirectly invest in the commodities market through mutual funds that invest in such businesses.
Traditional Investments vs. Alternative Investments
Today, many alternative investments offer higher ROI than traditional investments, especially where risk adjustments are made. Additionally, alternative investments tend to perform better in periods of high market volatility.As far as diversification is concerned, alternative investments are the way to go. In fact, most investment advisors suggest that you hold one-fourth of your investment portfolio in alternative investments.
Nevertheless, traditional investments continue to hold sway in many quarters due to their relative consistency and low risk. Additionally, the barriers to entry are usually lower than it is for alternative investment, while the assets involved are highly liquid.
Indeed, traditional investments are the best choice for investors seeking to accrue wealth in a risk-averse, steady manner. The capital required for investment is low, while the assets are traded in transparent public markets.
