Alternative investments? Understand the risks first

Investment options offering (and promising) double-digit returns regularly appear in advertisements and news headlines. In an overcrowded investment universe, these attract attention, and investors are, of course, enticed by what seems like superior returns to other investment products.

However, while the appeal of high returns is strong, it is crucial to look beyond the numbers and fully understand the risks involved. Investors need to consider different factors that align with their financial goals, risk appetite, and liquidity needs.

Alternative options

Unlike traditional investments such as stocks, bonds, or cash, alternative investments span a broad range of assets that do not trade on public markets. These investments often offer diversification and the potential for higher returns, but they also come with increased risk and complexity.

In South Africa, common alternative investments include real estate, private equity, commodities, collectables, cryptocurrencies, and infrastructure projects. Each of these asset classes presents unique opportunities, but they also carry inherent risks that investors must carefully evaluate before committing capital.

The myth of ‘guaranteed growth’ in alternative investments

One of the most misleading claims in the investment world is the notion of a “guaranteed growth” portfolio in alternative assets. No investment is entirely risk-free. While some alternative investments may yield higher returns than traditional options, they also carry the possibility of significant loss.

The level of risk varies depending on the investment type. Real estate, for example, is often perceived as a safer bet compared to private equity, yet both are influenced by market fluctuations and broader economic conditions.

Investors must conduct thorough research and ensure they understand the risks involved before allocating funds to alternative investments. Seeking guidance from a financial advisor can help clarify whether an investment aligns with individual financial objectives and long-term plans.

The risks of unlisted alternative investments

One of the biggest challenges with alternative investments is their lack of liquidity. Unlike publicly traded stocks, which can be bought and sold relatively easily, many alternative assets have no open market, meaning investors may have to wait years before they can access their capital. This illiquidity can be a major drawback for those who might need to cash out sooner than expected.

Another significant issue is valuation. Unlike listed shares, which have clear and transparent market prices, alternative investments often rely on subjective valuation models. This lack of clarity increases the risk of overpaying for an asset or misjudging its actual worth.

Many alternative investments also expose investors to the possibility of substantial losses. Private equity and venture capital, for example, target niche and often speculative markets where there is a real risk of losing the entire investment. History has shown that poorly structured alternative investments can lead to disastrous financial outcomes for unsuspecting investors.

Regulatory oversight is another key concern. Many alternative assets do not fall under the same stringent regulations as, for instance, JSE-listed securities, making them more susceptible to fraud, poor management, or operational failures. Without strong governance, investors may find themselves at the mercy of unreliable investment structures that lack transparency and accountability.

The complexity of many alternative investments also poses challenges. Unlike traditional assets, which are relatively straightforward to understand, alternative investments often involve intricate strategies and financial structures. Without the necessary expertise, investors can easily underestimate the risks involved.

Furthermore, alternative investments often require high initial capital commitments. This not only limits diversification but also exposes investors to higher fees, which are sometimes hidden within fund pricing structures. Many investors fail to recognise the impact of these fees on long-term returns, especially when they are not clearly disclosed.

Lastly, the biggest misconception surrounding alternative investments is the belief that high returns are guaranteed. While some firms advertise double-digit profits, market downturns, mismanagement, and broader economic conditions can quickly erode expected returns. There is always a risk that an investment will not perform as expected, and in some cases, investors may end up losing money rather than gaining it.

Looking beyond returns: What investors should consider

When evaluating alternative investments, it is essential to look beyond the promise of high returns and assess whether the risks align with financial goals. Investing is not just about chasing profits – it is about achieving a balance between risk and reward.

Before committing to any alternative investment, investors should ask themselves several critical questions. Do they fully understand what they are investing in? As Warren Buffett famously said, “Never invest in a business you cannot understand.” Investors should take the time to research the underlying assets and strategies before making a decision.

Understanding the costs associated with an investment is equally important. Many alternative investments come with high management fees and performance-based charges. If performance fees apply, it is crucial to determine how they are benchmarked to assess whether the investment’s performance justifies its risks and costs.

Another key consideration is liquidity. Investors need to understand how long their capital will be locked in and whether they will have access to their funds if circumstances change. Many alternative investments require capital commitments ranging from three to seven years, during which selling is either restricted or comes with penalties.

Assessing the risk profile of an investment is another critical step. A thorough risk analysis should be conducted before making any commitments, and investors should request scenario analyses to understand potential downside risks.

The credibility of the investment manager also matters. Who is managing the investment, and what is their track record? An investment’s success often depends on the expertise and experience of those managing it. Investors should conduct due diligence to ensure they are entrusting their money to reputable and skilled professionals.

The role of a financial advisor in alternative investments

A responsible financial advisor plays a crucial role in helping investors navigate the complexities of alternative investments. Their responsibility is to protect clients’ financial interests by ensuring proper due diligence is conducted before recommending any investment opportunity.

An advisor should also provide transparent and unbiased advice, prioritising the investor’s long-term financial well-being over short-term market hype. With so many alternative investments being marketed with aggressive sales tactics, having a knowledgeable advisor can help investors separate sound opportunities from those that carry unnecessary risks.

The bottom line is that alternative investments can be a valuable addition to a diversified portfolio, but they require careful consideration. No investment is without risk, and the potential for high returns should never overshadow the need for thorough research and strategic planning. Understanding both the rewards and the risks is key to making informed investment decisions that support long-term financial success.