You probably have too few alternative investments

torsdag, 2. december 2021

Article from finans.dk

Do you have too many eggs in one basket? If you’re only betting on common, listed stocks and bonds, you’re missing out on returns. You can get higher expected returns at lower risk if you also include other types of investments in your portfolio.

Most retail investors are familiar with listed stocks and bonds, which are regularly featured in the media and are part of most people’s investment portfolios, retirement accounts, etc. However, retail investors’ knowledge and experience with alternative investments is still quite limited. Unfortunately, this means that they expose themselves to greater risk and receive a lower return than necessary.

Alternative investments is an umbrella term for everything that is not normal listed stocks and bonds. Real estate investment is probably best known among alternative investments, but there are many other types of alternative investments. These include solar farms/wind turbines, unlisted limited companies, unlisted bonds, hedge funds and much more.

Most alternative investments are characterized by high transaction costs and limited turnover. They are difficult to trade and consequently typically have a long investment horizon. This may be one of the reasons why too few private investors have had the courage to take the plunge. However, alternative investments often have a higher expected return relative to the risk than easily tradable investments – precisely because investors can generally demand a higher return in exchange for a longer investment horizon.

In other words, investors in alternative investments typically get a higher return because they cannot withdraw their money at short notice. This is also why pension funds, which have very long investment horizons, have significantly increased their allocation to alternative assets in recent years. Wealthy individuals have also started to increase their investments in alternative investments – but in many cases they still have very few or none at all.

Although there are also significant differences among pension companies, they have now generally invested around 25% of pension savers’ funds in alternative assets. This proportion is even still increasing, which makes sense in an investment environment where the stock market is likely to deliver returns of only 2-5% over the next ten years, while bonds are at around zero (assuming interest rates do not rise).

There are apparently no statistics for Danes’ alternative investments, so readers must rely on my assessment, which is based on knowledge of hundreds of wealthy Danes’ portfolios in various banks. Based on my knowledge, I must conclude that the vast majority of ordinary investors (up to DKK 3 million in invested wealth) do not have any alternative investments in their portfolio. For slightly wealthier investors (DKK 3-10 million), the vast majority have less than 5% allocated to illiquid investments.

Even fairly wealthy investors with DKK 10-50 million have in most cases invested less than 10% of their wealth in alternative investments. As a result, they miss out on both returns and a significant diversification gain across the board. In other words, they can get a higher return for the same risk or the same return for lower risk (or a combination of both) if they include alternative assets in their portfolio.

The very low proportion of portfolios invested in alternative investments cannot be explained solely by the fact that there are only a few years until retirement and that the wealth must be “available” at that time. I believe it is instead due to a lack of knowledge of these types of investments, but also that the cost of advice due to certification requirements may be too high in the banks.

My assessment is that in the vast majority of cases, investors should have an allocation of 25% to alternative investments – just like pension funds. If you have many years until retirement, you should in many cases have an even higher allocation.

Read the article (in Danish) on finans.dk here

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