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9. Alternative investments

Mindfully Investing focuses on the three mainstream investments of stocks, bonds, and cash, which I introduced in Article 6.  However, many additional investing options exist.  In this article, I’ll briefly consider the world of so-called “alternative investments”, and whether any of them might fit into a mindful investing portfolio.

At its core, an investment is almost anything you purchase that you expect to generate income or appreciate in value.  While I can’t name every investment in the world, the most readily available and common alternative investments include:

  • Real estate
  • Gold
  • Annuities
  • Commodities
  • Currencies (foreign exchange and cryptocurrencies)
  • Peer-to-peer lending
  • Derivatives (options and futures)
  • Collectibles and art

In the rest of this article, I’ll briefly describe each of these alternative investments and discuss whether they might belong in a mindful investing portfolio.  Unlike most Mindfully Investing articles, it’s not practical to dive deep into each and every alternative investment.  Instead, I’ll briefly evaluate them using the four cornerstones of mindful investing, which are: rationality, empiricism, patience, and humility.

Real estate

It’s funny that people think of real estate as an “alternative investment” when 64% of U.S. families own a home, but only 54% of the U.S. population owns stocks.  And 10 of the 18 portfolios suggested by finance big-wigs and analyzed at Portfolio Charts have substantial allocations to real estate.  Beyond your main home, you can invest in real estate dozens of different ways, which I’ll lump into two broad categories discussed in the next two subsections.

Real estate investment trusts (REITs) – REITs are companies that own, operate, or finance income-producing real estate in a range of property sectors.  Most REITs issue publicly-traded stock that you can easily buy and sell like any other stock, including in mutual funds or Exchange Traded Funds (ETFs) that contain the stocks of many REIT companies.  And just like any other stock, you can make money on REITs through both dividend payments and price appreciation.  There are many kinds of REITs that I won’t go into here, some of which are not publicly traded.

In recent history, REITs have often been pretty highly correlated with the wider stock market as shown in this graph from Ben Carlson.

As a result, REITs have often provided very stock-like returns and volatility.  This graph and table, generated using Portfolio Visualizer, compare the performance since 1994 of U.S. REITs (blue line Portfolio 1), the entire U.S. stock market (red line Portfolio 2), and a 50/50 mix of REITs and U.S. stocks (gold line Portfolio 3).

Stock Type Annualized Return (CAGR) Volatility (St. Dev.) Best Year Worst Year Maximum Drawdown
REITs 9.3% 19.3% 35.7% -37.1% -68.3%
U.S. Stocks 9.3% 14.9% 35.8% -37.0% -50.9%
50/50 REITs and Stocks 9.3% 15.5% 33.4% -37.0% -59.5%

Although they took different paths along the way, both the REIT and U.S. stock portfolios ended up with the same annualized return of 9.3%.  But REITs were more volatile, including an absolutely stomach-churning maximum drawdown of nearly 70%.  And this happened right when many folks were hoping that property values would rescue them from the quicksand of the 2008 financial crisis.  The combined 50/50 portfolio had lower volatility than the REIT portfolio, but the all-stock portfolio still had the best-combined metrics for this period.

I’ve always cautioned against putting too much weight in any single comparison of assets over one timeframe.  Over the total time that REITs have figured prominently in the stock market, having REITs in your portfolio produced a negligible long-term benefit.  Of course, the next 25 years could turn out completely different, and it’s entirely possible that adding some REITs today might help your stock portfolio weather some unexpected storms tomorrow.  Therefore, to the extent you see value in diversifying across different stock sectors, REIT stocks may be a solid part of your investing plan.  But adding some REITs to your portfolio is certainly no guarantee that you’ll get consistently better performance or protection from the next market downturn.  If you’re interested in REITs as an easy way to add real estate to your portfolio, this post provides some additional details.

Traditional real estate – Traditionally, buying real estate means buying a property with a physical address, or part of such a property, or part of many such properties.  The property could be houses, rental properties, vacant land, farms, part of buildings like a condo, whole buildings, or drive-in theaters for that matter.  Here are a few obvious examples of the dozens of ways to make (or lose) money on traditional real estate:

  • Main home (buying outright, buying with a loan, rent-to-own, etc.)
  • Vacation property
  • Long-term rental property
  • Short-term rental property (such as Airbnb)
  • Real-estate investment groups
  • Timeshares
  • Flipping houses
  • Crowdfunded real estate (such as Fundrise or Realty Mogul)
  • Commercial/industrial property

Many people see an inherent advantage in traditional real estate investing because local banks will often loan most of a property’s purchase price, which is called using “leverage”.  Leverage can theoretically boost the returns from a given capital outlay.  However, leverage is a two-edged sword, whether you use it for real estate, stocks, or anything else.  What if property values go down (like they did in 2008), or your tenants fail to pay the rent for months on end, or someone starts a meth lab in your basement?  Regardless, you’re still obligated to make regular loan payments and eventually pay the entire loan back with interest.  I’ve seen myriad potential financial problems that come with real estate investing, and leverage makes all of those problems worse.

Regardless of leverage, it’s difficult to document the historical returns and volatility of real estate because of all the particulars involved with real estate like location, type of property, regional economies, etc.  I conducted an evaluation of real estate returns and volatility that tried to be as objective and “average” as possible.  I used median U.S. house price data, and you can read about more details of the analysis here.  Below are two graphs summarizing the results of the analysis from 1963 through 2017, assuming that $10,000 was initially invested in:

  • A main home or vacation property that is not rented (the “House Price” scenario)
  • A rental property with 4% net rent (“House Price + 4% Rent”)
  • A rental property with 6% net rent (“House Price + 6% Rent”)
  • Bonds represented by 10-Year government bonds.
  • U.S. stocks as represented by the S&P 500

Here’s a graph of the results.

And here’s a table of the results for the same scenarios.

Scenario Final Value Annualized Return (CAGR) Best Year Worst Year No. of Houses Acquired
House Price  $189,831 5.42% 17.37% -9.2% 1
House Price + 4% Rent  $766,629 8.06% 16.55% -3.5% 4
House Price + 6% Rent  $1,406,094 9.22% 20.33% -1.5% 8
10 Year Bond  $282,884 6.23% 32.81% -11.1% NA
Stocks – S&P500  $2,249,405 9.93% 38.46% -37.2% NA

Stocks are the clear winner in terms of final value, at least in this period from 1963 through 2017.  But the difference in annualized return between stocks and real estate with 6% net rent is less than 1%.  This suggests that rental houses in specific cities and periods could beat concurrent total stock market returns.  Conversely, the “house price” scenario is analogous to the return on your main home, and this analysis shows that the median U.S. home was a much worse investment than even government bonds, at least in this period.  The same conclusion applies to a vacation home that’s never used as a rental.

Are rental properties better than stocks as an investment?  Unless the net rental rate is around 6% or higher, stocks have generally performed better.  But it’s a virtual tie between stocks and rentals in regions where 6% net rent is possible, which is mainly in low-cost-of-living areas away from the east and west coast states of the U.S.  For example, I can say from experience that 6% net rent is impossible in Seattle or the rest of Washington State.

Hassle factors likely break the tie between stocks and traditional real estate for most people.  Rental income is relatively difficult to compound consistently because you have to constantly monitor and control rent expenses, keep up on maintenance, work to avoid periods of vacancy, etc.  Based on my experience, calling rental income “passive” is laughable, particularly if you’re trying to surpass the comparatively effortless long-term returns available from stocks.

On the other hand, the mindful perspective on diversification is that we can never predict the future.  Because no one knows what will happen next, moderate amounts of diversification across high-return investments, like stocks and traditional real estate, is prudent.  While assessing the chances that your real estate holdings will zig when the stock market zags is nearly impossible, traditional real estate prices and rents are much more driven by local conditions that are somewhat insulated from national stock market gyrations.  And with real estate investing, you have greater potential control over your returns by applying local knowledge, studying what makes properties in your area valuable, selecting quality tenants (within the bounds of fair housing laws), improving your do-it-yourself skills, etc.

Gold

Gold may be the most popular alternative investment.  Gold is a precious metal that’s been used for thousands of years as decoration and money.  Today, you can invest in gold two different ways.  You can buy physical gold (like buying gold coins or bullion), or you can buy funds that invest in physical gold.  Gold doesn’t include investing in gold mining companies, which is just another type of stock investment.

Stocks, bonds, and cash pay returns in the form of price changes as well as dividends or interest.  In contrast, the only way you can make money from gold is when somebody wants to buy it from you at a higher price than you originally paid.  Gold is a pretty unique investment in a number of other ways that I detail in this post.

Returns – When looking at returns histories, it’s often best to take the long view, like in this graph of real (inflation-adjusted) gold prices from a presentation by researcher Claude Erb:

There were long periods where an investor could have doubled their real value on gold (from about 1250 to 1500) and long periods where an investor could have lost 80% of their real value on gold (from about 1500 to 1950).  Erb examines other evidence of gold’s value over the last 3,000 years and calculates an average annual return somewhere between 0.5% and 2%.  In contrast, U.S. stocks have generated an average annual return of about 9% over the last 150 years.

Let’s look at the potentially more relevant and recent period from 1975 (the end of the gold standard) to the present using Portfolio Visualizer.  The growth of an initial $10,000 investment is shown in the graph below in nominal dollars (not inflation-adjusted).  The blue line is stocks (Portfolio 1), the red line is bonds (Portfolio 2), and the gold line is, well, gold (Portfolio 3).

Risks – Here’s a table showing the volatility (and return) data for these same scenarios, as well as cash.  Additional details of this analysis are described here.

Asset Average Annualized Return Volatility (Std. Dev.) Worst Year Maximum Draw Down
Stocks 11.7% 15.1% -37.0% -50.9%
Bonds 7.3% 8.3% -10.2% -15.8%
Gold 4.3% 18.8% -32.6% -61.8%
Cash 4.6% 1.0% 0.0% 0.0%

If you invest in gold, you should prepare yourself for low cash-like returns, high stock-like volatility, and drawdowns that would test the equanimity of the most adventurous investor.

So, why would anyone invest in gold?  I’ve discussed here several reasons that people invest in gold.   Most of them boil down to using gold as a type of “ballast” in a portfolio composed mostly of stocks.  The idea behind ballast is that stocks provide the main engine driving portfolio returns, and less volatile (and lower return) assets such as bonds or cash act as ballast that helps dampen the portfolio’s overall volatility.  We can see how well gold functions as ballast from 1975 to present in this table, which compares the returns and volatility of portfolios composed of different types of 50% ballast (bonds, cash, gold) combined with 50% stocks.  A 100% stock portfolio is also included for comparison.

50/50 Assets Average Annualized Return Volatility (Std. Dev.) Worst Year Maximum Draw Down
Stock/Bond 10.4% 11.4% -25.5% -38.0%
Stock/Cash 10.1% 12.0% -33.1% -45.8%
Stock/Gold 10.1% 14.2% -33.2% -46.6%
100% Stock 11.7% 15.1% -37.0% -50.9%

Gold ballast causes a drag on portfolio returns similar to that of cash and bonds.  But in terms of volatility, gold is poor ballast, because it hardly reduces portfolio volatility as compared to the all-stock portfolio.  While you could use gold as a wacky sort of ballast, it often performs this function worse than bonds and cash.

Returns and risks revisited – Also, it’s important to realize that some investors are attracted to gold because it has performed much better over select periods of time.  For example, look at the returns and volatility of stocks, bonds, gold, and cash since the year 2000, which happens to be when I started seriously investing.

Asset Average Annualized Return Volatility (Std. Dev.) Worst Year Maximum Draw Down
Stocks 5.2% 15.0% -37.0% -50.9%
Bonds 5.1% 7.4% -10.2% -10.2%
Gold 7.8% 16.7% -28.3% -42.9%
Cash 1.6% 0.5% 0.0% 0.0%

For my entire investing life so far, gold provided by far the best returns.  Gold did a great job of withstanding two major stock market crashes and a global near-collapse of the financial system, all while outperforming bonds during a historic bond bull market.

This is a good reminder of one of the four cornerstones of mindful investing: humility.  While back-testing is useful and necessary, we understand that no future period will be exactly like the past.  Markets, in gold or anything else, are inherently unpredictable.  However, I would say that the history of gold is even less predictable than that of stocks, which have shown remarkable resilience for at least 150 years in the U.S.  Because stocks are ownership in usually growing and productive companies, they’ve repeatedly bounced back from temporary crashes and into relatively long periods of superior returns.  In contrast, the fickle demand for gold will likely continue to cause highly erratic returns into the future.

Annuities

An annuity is an insurance product that you purchase (invest in), and it provides a regular (usually monthly) source of income.  That sounds pretty simple, but it’s not.  I think it’s fair to say that annuities are one of the most hated investments around, because of their complexity, relatively high costs, and relatively poor returns, which I’ll detail in a moment.

I’m not going to try to describe all the different types and nuances of annuities here, because many good websites already have that information (for examples see herehere, and here).  You don’t need to explore much to see that the jungle of annuity products is murky, dense, and confusing.  Just a quick flyover of annuity names exposes the morass: fixed annuities, variable annuities, equity-indexed annuities, immediate annuities, longevity annuities, and others.  Each type of annuity has myriad overlapping variations such as “indexed fixed annuities”.  And all annuities come with complex contracts that you need to fully understand, at least if you’re taking a mindful approach to investing.

Returns – A study from 2007 to 2012 found that the average nominal annualized return for an indexed fixed annuity ranged from 1.2% to 5.5%.  That compares poorly to even very safe investments like U.S. 10-year government bonds, which had a nominal annualized return of 6.7% over this same period.

Risks – Salespeople mostly emphasize that annuities provide the certainty of a regular income stream regardless of how much the stock and bond markets may tumble.  Put another way, insurance companies sell annuities by stoking investor’s fears about mainstream investment volatility.  As I’ve noted before, mindful investing is all about avoiding counterproductive decisions driven by emotions, particularly fear.  In my view, the primary risk associated with annuities is that you’ll buy something you don’t fully understand.  As a result, you might end up with less income or less access to funds than you expected over the life of the annuity.

Because annuities have poor returns and exist mainly to allay irrational fears, they don’t appeal much to the mindful investor.

Commodities

Commodities are raw materials used commercially or in industry.  Although many things are called commodities, if you want to invest in a commodity, it needs to be traded on an exchange somewhere.  Tradable commodities include:

  • Industrial Metals – copper, lead, zinc, aluminum, and others
  • Precious Metals – gold, silver, platinum, and palladium
  • Energy – Crude oil, natural gas, heating oil, gasoline, and others
  • Food and Fiber – Corn, oats, rice, soybeans, wheat, milk, sugar, cocoa, coffee, cotton, and others
  • Livestock and Meat – Hogs, pork bellies, and cattle

You’ll note that gold is one of the precious metal commodities.  Above, I conducted a separate evaluation of gold mainly because it’s the most popular of the commodities for individual investors.

For most individual investors, the easiest way to invest in commodities is through Exchange Traded Funds (ETFs), Exchange Traded Notes (ETNs), or mutual funds.  In most cases, these funds use futures contracts (see derivatives below for more on futures) to track the price of a particular commodity or group of commodities in an index.  You can also get exposure to commodity price movements by investing in the stocks of companies that produce or handle that commodity.  But this is just a particular type of stock that is best viewed through the larger lens of stock investing.  Finally, you could simply buy a physical quantity of the commodity.  While this might be possible for gold, having a silo full of wheat in the back yard isn’t practical for most investors.

Returns – Like gold, you can only make money from commodity funds through price appreciation.  One school of thought says that commodities are an inherently inferior investment because price appreciation is mostly determined by capricious market supply and demand cycles.  In contrast, stock returns reflect the efforts of company managers who are constantly trying to grow and add to the company’s fundamental value, often while issuing dividends along the way.

As a result, long-term returns for commodities are often poor, as shown in this graph comparing an initial $10,000 investment in the oldest commodity fund available (red line Portfolio 2) as compared to stocks in the S&P 500 as represented by the SPY ETF (blue line Portfolio 1).  I generated the graph using Portfolio Visualizer.

Risks – Here are some select volatility (and return) statistics for these two funds over this period.

Portfolio Final Balance Annualized Return (CAGR) Volatility (St. Dev.) Maximum Draw Down US Market Correlation
Stocks – S&P 500 (SPY) $43,374 9.50% 13.44% -50.80% 1.00
Commodities – PCRCX $9,827 -0.11% 19.25% -66.78% 0.47

 

While it’s always dangerous to draw definitive conclusions from less than two decades of data, commodities have been a lousy investment since 2003 in terms of returns, routine volatility, and maximum drawdowns.  And there’s certainly nothing stopping commodities from having similar or even worse results in the next couple decades.

Another school of thought sees commodities as a hedge against mainstream investments (mainly stocks) for the same reasons I presented above for gold.  Many commodities are materials that remain useful and valuable even during certain kinds of economic crises.  But the data table shows the correlation between commodities and stocks has been substantially positive since 2003 (0.47), which means that commodity returns often failed to move in the opposite direction of stock returns.

Why would anyone invest in commodities?  The best clue is given by the period around 2007 and 2008 in the above graph when commodity prices temporarily spiked.  If you’re mainly interested in investing as a short-term trading exercise, then commodity volatility could seem appealing.  But this assumes that you can pick just the right times to jump into and out of the commodities markets.  I’ve explained copiously that such short-term market timing is impossible with any consistency and is not a mindful way to invest.

The evidence suggests that investing in commodities is not mindful, due to the potential for low long-term returns, high volatility, and inconsistent hedging against mainstream investments.

Currencies

I’ll cover two types of currencies: traditional so-called “fiat” currencies and cryptocurrencies.  A country creates a fiat currency for local commerce that’s implemented and backed by the government.  Cryptocurrencies aren’t created or backed by any country.  They exist only as a form of digital exchange through computer calculations that track the ownership and value of each unit of currency.

Foreign exchange of fiat currencies – Investing in fiat currencies is all about exchanging one currency for another.  For example, if most of your assets are in U.S. dollars, and you think the dollar is going to decline in value relative to other world currencies, you can buy some euros with your dollars to cushion that decline.  The low cost and easy access to trading currencies can be alluring.  You can trade currencies directly through online brokers with no commission or indirectly by purchasing relatively low-cost currency ETFs or similar funds.

Just as the only source of commodity returns is price changes, you can only profit from currencies through often wild fluctuations in values relative to other currencies, which are driven by a plethora of unpredictable global events and economic interactions.  Further, for every profit made by a currency trade, there is an equal loss for other people trading in the exchange.  Once you factor in the payments to the brokers, which come from the careful setting of the exchange rates at any given moment, each currency trade results in a net loss across all investors involved.  With currency trading, the deck is stacked against you.

It’s also easy to exchange currencies using leverage levels as high as 50 to 1 or even 1000 to 1.  While large amounts of leverage create possibilities of huge gains, because of the zero-sum nature of the exchange, it also creates equal possibilities of huge losses well beyond the original capital outlay.  Losing money that you don’t even have is about as risky as it gets!

Why would anyone invest by exchanging currencies?  The main advantage of trading currencies is hedging against declines in the main currency of your assets.  If most of your portfolio is in U.S. dollars, buying some foreign currency might help counterbalance widespread portfolio losses if the U.S. dollar devalues.  This is an argument for global diversification.  But you can get this same sort of global diversification by instead buying foreign assets.  For example, almost all online brokers offer foreign stock and bond funds, which give exposure to companies and governments operating in many different currencies.

Some people emphasize other advantages to currency trading like a level playing field, a highly liquid market, round-the-clock trading, and low costs.  But that seems like recommending a restaurant that’s had frequent food-poisoning incidents based on criteria like comfortable chairs, ample parking, long hours of operation, and low prices.

Cryptocurrencies – A nauseating number of blog posts and online articles discuss investing in cryptocurrencies.  They range from ecstatic endorsements to dire warnings.  Rather than rehashing all that, I’ll retreat again to the four cornerstones of mindful investing.  From an empirical standpoint, there are almost no historical data to help estimate how cryptocurrencies might perform over the long term, as compared to, for example, the 147-year and 94-year histories of U.S. stock and bond returns, respectively.

From a humility standpoint, both pro and con cryptocurrency articles reveal that the currencies themselves are extremely complex and their markets are poorly understood and still evolving.  Most of us probably don’t have the abilities or know-how to successfully navigate such a brave new investing world.

From a patience standpoint, I’d wager that most people who invest in cryptocurrencies hope of becoming rich in a few months or years.  As this chart for one cryptocurrency (Bitcoin) shows, those who invested in 2016 were likely dancing in the streets at the start of 2018.  But those who invested in 2018, probably now feel like jumping into the street via the nearest window.

Because timing the market is impossible, get-rich-quick schemes are probably the worst possible motivation for investing.  On balance, investing in cryptocurrencies seems pretty irrational, at least at the current time.

Peer-to-Peer Lending

Peer-to-peer lending is a way for borrowers to get loans directly from individual lenders instead of conventional lending sources like banks.  The individual lender is investing their money by loaning it to one or more borrowers who are contractually obligated to return the loan, plus interest, within a specified period.  So, peer-to-peer investing returns come entirely from the interest paid back on the loans.

The internet is slowly disrupting the money lending business.  Banks have been the traditional matchmakers between people with money and people who want to borrow.  Peer-to-peer lending platforms sprung up in the early 2000s and have grown into a business that transacts $86 billion dollars in loans.  Unlike banks, peer-to-peer lending websites don’t make money from charging interest to borrowers; they charge fees on the facilitated transactions instead.  There are many peer-to-peer lending platforms that focus on different types of loans including:

  • Personal loans for just about anything
  • Personal loans to people with bad credit
  • Loans to start or expand a business
  • Loans for real estate investing
  • Student loans
  • Non-profit microlending.

To avoid inadvertent recommendations, I won’t list any peer-to-peer lending companies.

Returns – I found recent and credible accounts of investors obtaining anywhere from 2% to 11% annual returns from a few of the larger peer-to-peer lending platforms.  The platforms themselves report investor annual returns anywhere from “less than 0%” (losing money) to “greater than 15%”.  One popular platform reports the most common annual return for less risky portfolios as 6% to 9% and for more risky portfolios as 9% to 12%.

Given that the average annualized returns for stocks since 1871 is about 9%, a potential annual return of 9% to 12% sounds appealing.  But of course, the devil is in the details.  To get those higher returns, you need to loan money to people who have a higher risk of defaulting (not paying you back).  And finding the right balance between a good return and reasonable default rates depends on the focus of each platform, how it’s operated, and many other details.

Further, I found results and commentary from peer-to-peer investors indicating that returns have declined substantially in the last few years.  For example, Retire Before Dad reported his annual returns declining from 13.3% in 2014 to just 5.6% in 2019.  And Lend Academy reported returns of 12.4% in 2014 declining to as low as 4.5% in 2018.  The College Investor notes that perhaps the days of plus 10% returns are over for peer-to-peer investing due to competition and other factors.

Risks – The main way peer-to-peer platforms reduce default risk is through diversification.  For example, instead of loaning your entire $10,000 investment to one person, most platforms suggest or require that you spread that money around to many borrowers.   So, if one borrower defaults, many investors take a small ding in their return, which greatly diminishes the losses for any individual investor.  Some platforms also maintain reserves or insurance that they can use to minimize the impact of defaults on collective returns.

Of course, the return you get is highly dependent on the default rate within the group you’re lending to.  While all the platforms factor past defaults into future return estimates, the default rates are necessarily based on past data.  Given that most of these sites have existed for 10 years or less, the track record for these default rates is an order-of-magnitude less than the 147 and 94-year histories of U.S. stock and bond returns, respectively.  Past default rate estimates may be even less predictive of future rates because of changes in the economy or platform operating rules over the years.

I reviewed some personal anecdotes from various bloggers to get some sense of the potential divergence between expected return estimates and actual returns, which is one way to summarize default and other risks involved with peer-to-peer investing.  This table compiles the results.

Source Report Date Expected Annual Return Estimate Actual Annualized Return
Money Under 30 Oct-2019 10.5% 5.1%
Passive Income M.D.(platform A) Dec-2017 8.2% 5.2%
Passive Income M.D.(platform B) Dec-2017 7.5% 2.9%
ESI Money Jun-2017 7.3% 3.0%
Side Hustle Nation Feb-2016 9.6% 12.4%
Retire Before Dad Jan-2019 7.8% (est) 5.6%
PT Money Jan-2019 6.2% (est) 5.5%

You’ll note that actual returns above 9% were pretty rare.  Except for the oldest result, the actual returns were 1% to 5% lower than the investor originally expected.

Given that peer-to-peer lending is a relatively new industry, the potential for platforms to go out of business is another risk.  U.S. regulations require that platforms have a plan for resolving loans after a company fails.  But it’s debatable that such plans can guarantee zero impact on investor returns, considering all the unexpected chaos normally associated with a large business dissolving.

Therefore, the mindful conclusion about peer-to-peer investing is similar to Mindfully Investing conclusions about high-yield bonds.  Specifically, mindful investors should focus mostly on stocks.  To the extent your portfolio has some bonds to cushion against short-term stock declines, using high-yield bonds simply pushes your overall portfolio into a more risky profile that’s similar to holding more stocks instead.  Likewise, holding too much higher risk peer-to-peer loans starts to defeat the purpose of holding a combination of safer investments and more-risky stocks.

Derivatives

A derivative is a contract between parties where the value of the derivative is based upon an underlying asset or financial instrument such as stocks, bonds, commodities, currencies, or groups of such assets like an index.  The most common derivatives include a contractual agreement where parties:

  • Swap – Exchange one cash flow from some underlying asset for another cash flow under specified conditions in a “non-standard” contract (a contract devised by the parties involved).
  • Forward – Buy or sell an asset under a non-standard contract at a specified future time at a price agreed upon today.
  • Future – Buy or sell an asset under a “standard” contract (a contract devised by an intermediary) at a price agreed upon today (the futures price) with delivery and payment occurring at a specified future date.
  • Option – Gives the buyer the right under a standard contract, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specified date.

These derivative types are often further sub-categorized by the underlying asset involved, how they pay off, and the manner in which they’re exchanged.  There are even more complex derivatives such as credit default swaps, which were a key factor in the 2008 financial crisis, and collateralized debt obligations, both of which are only distantly related to an underlying asset.  There are many more flavors of derivatives that I won’t attempt to describe here.  But if you’re interested in finding out more, Investopedia is a good place to start.

Derivatives are mostly used to manage investing risks.  Depending on which side of the derivative contract you’re on, you can use them to either decrease risks associated with the underlying asset (called a hedge) or take on more risk in the hopes of achieving higher returns than would be available from investing directly in the underlying asset.

Returns – Because of the very nature of derivatives as a risk management tool, it’s impossible to generally characterize the returns available from derivatives.  Returns can vary from massive losses to theoretically astronomical positive returns.  The returns are entirely dependent on the particulars of the obligations and rights under the derivative contract.

Risks – For the same reason, it’s impossible to generally characterize the risks from derivatives.  It’s easy to buy a future or an option that loses money.  But that’s not always a bad idea.  For example, you might end up losing a bit of money as insurance against losing a much larger amount of money that you invested directly in an underlying asset.  It’s the same logic as homeowners’ insurance.  Even though your house didn’t burn down this year, it still makes sense to buy fire insurance next year.  However, it’s safe to say that derivative risks usually involve:

  • Value risk – In most cases, it’s almost impossible to know a derivatives “true” value.  The risk here is uncertainty about how others will value that derivative now or in the future.
  • Easy Leverage –  One or more parties involved in a derivative often use borrowed money (or leverage), which is relatively easy to obtain.  Putting up only one dollar for every 8 or 10 dollars in the contract is not unusual.  Easy access to leverage compounds the potential derivative losses.
  • Time Restrictions – Most derivatives have a time component.  So, you can have the right investing thesis (e.g., oil prices will go up by 10%) but still lose money because your timing was wrong (e.g., oil prices went up a month after your contract expired).

Unlike long-term stock or bond investing, derivatives force you to engage more actively in market timing, which is impossible with any consistency.  It’s certainly possible to make money through derivatives; it happens every day.  But a rational assessment suggests that acquiring the necessary expertise in one type of derivative or another involves a similar level of effort as starting a new business.  And this blog is primarily about investing your savings from your existing profession without having to moonlight on a second line of work.

Collectibles and Art

Judging from all the television shows about collectibles like Antiques Roadshow, American Pickers, Pawn Stars, and Storage Wars (to name but a few), people love the idea of making money on collectibles and art.  There’s an amazing array of things you can buy that have the potential to appreciate in value over time.  Here’s a less than exhaustive list based on some quick internet research:

  • Fine art paintings, lithographs, prints, photographs, sculptures, etc.
  • Pop, folk, tribal, and ancient art
  • Jewelry and watches
  • Stamps
  • Coins
  • Antique furniture, home furnishings, and decor
  • Rare automobiles, motorcycles, and other transportation
  • Rare arms and military memorabilia
  • Comic books
  • Baseball cards
  • Rare toys and games
  • Pop and sports memorabilia
  • Rare books, manuscripts, maps, and historical documents
  • Rare musical instruments
  • Wine

While “reality” television shows create hopes of finding that million-dollar treasure collecting dust in the garage or attic, in the real world that almost never happens.  On the other hand, if you already have specialized knowledge through an existing hobby or interest, it’s certainly reasonable to buy collectibles as an investment.

Returns – Because of the diversity of things you can collect, it’s impossible to say what the “typical” returns on collectibles are.  And unlike the stock market, where you can get a price quote in any given minute, collectibles are exchanged in much more esoteric and location-specific ways.  So, determining a fair value for collectibles is often extremely difficult.  The only safe generalization is that the more knowledge you have about an item, or can buy from an expert, the greater the potential returns.  And the less knowledge you have, the less chance you have of making a decent return.  Further, costs eat into returns, and the costs associated with investing in collectibles and art are generally higher than for mainstream investments.  Collectible investing costs can include research time, broker fees, expert help, appraisals, insurance, marketing, maintenance, restoration, and storage.

Risks – Given the esoteric nature of collectible and art markets, the values of most of these items are much more volatile than stocks.  Because of changing trends in tastes, styles, and interests, things that were once highly prized can become quickly worthless and vice versa.  Additional risks for collectibles and art include:

  • Illiquid – Collectibles and art may have an expected value only at certain times, places, or when you can find a particular kind of buyer.  It may take a long time before the perceived value is realized with a sale.
  • Counterfeits/Fraud – Imitations and misrepresentations exist for almost all types of collectibles and art, and some are very hard to detect.
  • Condition/Loss – Value is highly dependent on condition, and flaws or wear that seems unremarkable to you can greatly impact value.  And of course, the value of all your collectibles could be wiped out in one basement flood, unless you buy insurance, which eats into your returns.

For most of us, collecting fine art or expensive antiques is financially impossible.  So, it’s also worth noting that collectible and art funds have sprung up in recent years.  These private funds are purportedly run by experts that buy and sell physical collectibles or art.  By investing in one of these private funds, you are essentially owning a small piece of many works of art.  As compared to owning stock funds, art and collectible funds costs are often excessive, such as 1% to 3% in annual management fees plus a 20% cut of all profits.

More obscure alternatives

You can find even longer lists of alternative investments on the internet, which include things like: tax liens, tax credits, natural resource rights, intellectual property, structured settlements, venture capital, website investing, royalties, and warrants.  If you’re like me, you probably aren’t even sure what some of these things are.  Further, you can invest in a huge number of businesses, either by starting a new one or buying into an existing one.

Successfully investing in these more obscure alternatives requires highly specialized knowledge.  Determining whether you should invest in an ice cream factory versus a stud farm mostly boils down to how much you know, or are willing to learn, about those particular businesses.  Similarly, it would be pretty stupid to start investing in something like royalties or intellectual property without first conducting extensive research.

For these highly obscure investing options, humility is the most helpful of the four cornerstones of mindful investing.  Taking an objectively humble view of our abilities, it’s unlikely that most of us could immediately and effectively compete against investors with years of experience in one of these areas.  Time spent learning the ropes usually means time spent losing money.  Like investing in derivatives, a rational assessment suggests that acquiring the necessary expertise in one of these obscure investments would be like starting a new business, which is not what this blog is about.

Conclusions

Using the four cornerstones of mindfulness, we’ve found that most investors probably have no need to diversify into alternative investments.  It’s remarkable that alternatives continue to proliferate because most of them appear to have little hope of providing a balance of returns and risks that’s better than stocks.  This reinforces the old adage, “There’s no free lunch on Wall Street.”  But that doesn’t seem to deter people from trying to find a free lunch anyway.

The one alternative investment that reasonably competes with stocks is traditional real estate.  In particular, rental properties have the potential for stock-like returns along with a reasonable level of risk that can be managed to some extent.   Real estate has the additional benefit of potentially low correlation with stock movements during some types of market crises.  The catch is that successfully investing in high-performing rental properties is considerably more difficult, complicated, and time-consuming than investing in stocks.  Real estate is certainly much less “passive” than investing in stock index funds.