An Alternative to What?

Right around the beginning of the financial crisis in 2008, the term “alternative investment” became a more popular and widely used phrase in the investing universe. Primarily, the introduction of alternatives to more and more individual investors has driven this. In the past, institutional investors — like pensions —  were the main players in the segment.

To this day, I still get many puzzled looks — for lack of a better term — when the topic comes up. Often, I think the uncertainty comes down to a mix of sometimes overused flash phrases in the investing world and also just a plain and simple question: An alternative to … what?

So let’s explore what an alternative investment actually is. In essence, it’s a couple of things — but I think it’s all best explained starting with what it’s not.

Traditional investments

To have an alternative, you must first have the traditional. Traditional investments, at least for the purpose of our discussion, are the things that most individual investors — homeowners or not — have been using for decades. These are things like corporate stocks, bonds, mutual funds, and cash. However, it is not only what a traditional investment is but also how investors use traditional investments. Traditional investing also implies being “long” a particular investment — or buying and holding without plans to sell — and attempting to profit when the price moves up.

And their alternatives

Then you have the alternative. What “alternative” essentially implies here is that when the traditional zigs, the alternative zags. This means that what happens to the price of a traditional investment has no bearing on what happens to the price of an alternative investment — and vice versa. To utilize one of those overused flash phrases, we call this “low or negative correlation” in the investing world.

Earlier, I mentioned that an alternative investment is actually a couple of things, and here is where utilization comes into play. First, you have alternative assets — think of things that are not corporate stocks, bonds, or cash. Perhaps that means gold, silver, or other commodities like wheat or oil, and then even something like real estate or cryptocurrencies.

Alternative strategies

Next there are alternative strategies. If the traditional strategy attempts to profit from a price moving up, an alternative strategy may attempt to profit from a price moving down. Something we call being “short.” An alternative strategy may also involve a combination of being “long” and “short.” This is an attempt to tease out the relationship between the alternative itself and a traditional investment while still attempting to maintain a bias of profiting from upward price movement.

Now I’ll put on a bigger financial nerd hat here for a moment. The main benefit of utilizing an alternative investment within a well-diversified portfolio is the low or negative correlation. The math behind variability of returns — a way to measure risk — works out like so: If two investments have an identical measure of variability of returns independently, their overall variability of returns, when combined together, will be lower if their correlation to each other is low or negative. At least by this measure, lower variability of returns means less risk. It’s really cool stuff.