In three posts this year I’ve covered the so-called “alternative” investments of gold, Real Estate Investment Trusts (REITs), and Traditional Real Estate. Gold and
What Are Alternative Investments?
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 alternative investments include:
- Annuities
- Commodities
- Currencies (foreign exchange and cryptocurrencies)
- Peer-to-peer lending
- Derivatives (options and futures)
- Collectibles and art
In the rest of this post, I’ll briefly describe and evaluate the first three of these alternative investments from a mindful perspective. My next post will tackle the last three. Unlike most Mindfully Investing posts, I won’t dive into a deep evaluation of each alternative. This series represents more of a quick scouting trip for alternative investments, to see if any of them are worth more than playful consideration. But first, we need a short detour into alternative investments that are even more obscure than the ones in the above bullet list.
Even More Alternative Investments
You can find much 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.
However, we can probably make some initial decisions about these obscure investments without a huge amount of study. We can first evaluate them using the four cornerstones of mindful investing, which are: rationality, empiricism, patience, and humility. Humility is the most helpful here. 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. A rational assessment suggests that acquiring the necessary expertise in one of these areas would be like starting a new business. Although starting a business certainly fits the broad definition of an investment, this blog is primarily about investing your savings from your existing profession without having to start an entire second line of work.
That brings us back to the more readily available alternative investments in the bullet list at the start of this post. Let’s tackle annuities, commodities, and currencies one at a time.
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, both because of their complexity and their relatively high cost, which goes together with relatively poor returns. For example, a study from 2007 to 2012 found that the average 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 an annualized returned of 6.7% over this same period.
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 here, here, 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 the “indexed fixed” annuities I used in the above returns example. And all annuities come with complex contracts that you need to fully understand, at least if your taking a mindful approach to investing.
Given all the reasons to hate annuities, why would anyone invest in them? One advantage you’ll see mentioned is that most annuities are tax-deferred. That means you only pay taxes on the income stream, although the IRS taxes that stream at ordinary income rates, which for many folks is higher than the tax rate for dividends or capital gains in taxable accounts. But typical retirement accounts like 401Ks and IRAs share this same tax-deferred feature, and they usually come with lower fees and the potential for higher returns. In my view, the only important tax differentiator between annuities and typical retirement accounts is that annuities don’t have annual contribution limits, while most retirement accounts do.
Tax benefits aside, sales people 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. I’ve written copiously that mindful investing is all about avoiding counterproductive decisions driven by emotions, particularly fear. The mindful investor is less concerned and driven by any fears associated with the routine market volatility. For this reason, a mindful portfolio is heavily weighted toward stocks, which are highly volatile but usually offer a high return. Because annuities have poor returns and exist mainly to allay the irrational fears of unmindful investors, we can probably skip doing any more homework here.
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, which includes:
- 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
If this list seems mundane, stranger things are exchanged in niche markets around the world. For example, you can speculate in amber at the Saint Petersburg Exchange.
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* 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 sort of practical for something like gold, having a silo full of wheat in the back yard isn’t realistic for most investors.
Stock and bond returns come in two forms: dividend/interest payments and price appreciation. But 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 PIMCO’s PCRCX commodity fund (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. PCRCX is the oldest diversified commodity fund I could find, which provides the longest period of comparison.
And here are some select 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 draw downs. 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, particularly stocks, because commodities are materials that remain useful and valuable even during certain kinds of economic crises. When stocks drop, commodity investors hope that market participants will view commodities as a safe haven, which can stabilize or even boost commodity prices. There are certainly times when this has happened, such as the lead up to the 2008 and 2009 economic crisis as shown in the above graph. But at least in this one case, any hedging effect from commodities was very short-lived. And if you look at the entire period, the table shows the correlation between commodities and stocks was substantially positive (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
Investing in 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 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, currency trades are a zero-sum game before costs. That is, 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.
It’s also easy to exchange currencies with borrowed money, using what’s called “leverage”. Leverage levels as high as 50 to 1 or even 1000 to 1 are accessible to almost anyone trading currencies.*** While leverage creates possibilities of huge gains, because of the zero-sum nature of the exchange, it also creates equal possibilities of huge loses 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. Of course, 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 are fundamentally different from the exchange of so-called “fiat” currencies like dollars and euros. A country creates a fiat currency for local commerce that’s implemented and backed by the government. But 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.
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’s 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 hazard 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 out 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.
Conclusions
The conclusions for Part 1 of this series are pretty straight forward. On a mindfulness scale from 1 (least mindful) to 10 (most mindful):
- Annuities are a low-return and high-cost asset that is marketed to people with an irrational fear of the stock market. Mindfulness score = 3
- Commodities are highly volatile, only provide returns through market-timing of price changes, and don’t provide a consistent hedge against stock movements. Mindfulness score = 2
- Currencies share the troublesome volatility and return characteristics of commodities, but with the added trouble of a zero-sum game and dangerously easy access to risky leverage. Cryptocurrencies offer huge additional uncertainties because of their newness. Mindfulness score = 1.
It’s pretty clear that you shouldn’t bother playing around with these alternative investments. Part 2 is coming soon, where I’ll discuss the mindfulness of peer-to-peer lending, derivatives, and collectibles.
* I’ll describe futures more in my next post under “derivatives”.
** Positive correlation of +1 means that two funds move together in lock step; they are “highly correlated”. A correlation of 0 indicates that one fund moves randomly with regard to the other; they are “uncorrelated”. A negative correlation of -1 means that the two funds move exactly the opposite of each other in equal amounts; they are “negatively correlated”.
*** Basically, these ratios mean that, for example, you could exchange 50 or 1000 euros with the equivalent of only one euro deposited in your brokerage account.
