Picture this: Through hard work, good fortune or both, you’ve achieved substantial wealth. When your means were modest, a balanced diet of low-cost, plain-vanilla bonds and stocks seemed fine. But now, you qualify as an “accredited investor,” with increased access to a banquet of tempting new alternative investments … hedge funds, private equity ventures, non-traded REITs, etc.
Should you feast on these exotic new offerings?
The short answer is: Proceed with caution. Extreme caution. As I explain in this more detailed Q&A, most alternative investments are more likely to detract from than enhance your ability to earn highest expected, risk-adjusted returns. I hate to break the bland news, but your most satisfying investments already are found among those low-cost, plain-vanilla asset class funds.
And yet, despite mostly disappointing, after-cost track records, alternative investments continue to entice a broad swath of affluent investors who queue up to sign up. Why is that? Behavioural finance informs us: This is what happens when we let our emotions get ahead of our rational resolve. To name a few of the behavioural temptations particular to alternatives, there is:
- The allure of exclusivity –High-net-worth investors may feel they’ve “graduated” beyond stocks and bonds or even mutual funds for that matter, to some higher level of investment opportunity (despite all the evidence that the essential elements of efficient investing remain about the same no matter how much or little money is involved).
- The stealth of the status symbol– In his behavioral finance book “What Investors Really Want,” Professor Meir Statman describes how alternative investments often appeal more for their “looks” than the substantive returns they’re supposed to deliver. As Prof. Statman commented in this recent interview, “[The rich] can just say, I’m into hedge funds, and we know that you’re rich without you having to brag about it.”
- The call of the wildly implausible – Investors also are forever seeking low-risk/high-reward miracles that alternative investment product providers are happy to promise – at least until you read the fine print. This, despite the reality that premium returns from low-risk ventures are about as frequently seen as hockey pros with perfect teeth.
Once we get past the behavioural biases, what makes the most sense for wealthy investors is usually the same thing that make the most sense for every investor: low-cost, globally diversified portfolios, managed to reflect one’s personal goals and risk tolerances. While the purveyors of alternative investments may woo you with “champagne wishes and caviar dreams,”a steady diet of evidence-based investing should be far more nourishing in the long run.