Understanding the Risks of Investing in Complex Alternative Investments

Alternative investments offer higher returns but often come with increased risks. It is essential that you understand both your financial goals and risk tolerance before considering adding these types of investments to your portfolio.

Nontraditional assets typically feature low correlation to traditional markets and can help reduce portfolio volatility, while simultaneously incurring complex fees and increasing levels of risk.

Liquidity

Liquidity refers to how quickly an investment can be converted to cash without incurring significant value losses, making it one of the key factors influencing return potential of complex alternative investments.

Alternative investments rely on leverage strategies to increase returns, which may produce higher potential gains but increases the risk of losing principal.

Due to being private investments, alternative investments may not adhere to the same reporting standards as publicly traded ones. This can sometimes lead to reduced transparency and higher risks of fraud, misconduct and technical failure; however, recent advances in disclosure and regulation can provide greater assurance for investors.

Valuation

Valuation is an integral component of financial instruments. Valuing alternative investments can be particularly challenging due to their illiquid nature, unique payment structures, extended maturities or other terms which may impact strategic planning or investment decisions.

Many alternative assets have high minimum investment requirements and fees compared to traditional investments like mutual funds and ETFs, making it more challenging to locate service providers who can assess and value these unique investments accurately. Furthermore, providing consistent, verifiable financial data on them poses considerable operational risk, leading to regulatory issues as well as reputational damage due to inaccurate valuation.

Operational

Alternative investments often face misconceptions and confusion among investors; yet they can play an essential role in portfolio diversification, premium income generation potential, and reduced volatility.

However, investing in alternative investments carries with them unique risks that differ from investing in traditional assets, including valuation issues for hard assets like Contemporary Art or classic cars, and long lock-up periods in hedge funds and private equity funds that make selling investments difficult. Furthermore, investing in alternatives may require special knowledge and research; hence it must be carefully assessed within your investment objectives and risk tolerance before being made an investment decision.

Market

All investments involve some risk of financial loss. Alternative investments may employ leverage to enhance returns, increasing potential losses. Furthermore, they could be subject to political or market risks which negatively impact performance.

Alternative investments offer multiple advantages – portfolio diversification and diversifying away from traditional financial assets – but are complex and unregulated, with limited transparency and higher minimum investment requirements, making them challenging for individual investors to access. Speak to your wealth management professional about whether an alternative investment strategy might be right for you. 2024 Morgan Stanley Smith Barney LLC, Member SIPC. All rights are reserved.

Regulatory

Alternative investments often operate under distinct regulatory structures from what investors are used to, leading to complex investment structures and less transparent reporting practices.

Diversifying your portfolio with alternative assets can help protect against risk and increase returns, but it’s important to understand their unique risks as well as their effect on your overall financial goals.

Alternative investments were once exclusive to larger institutional investors, but are increasingly accessible to smaller organizations and individual investors alike. But it is important to avoid common misperceptions about this new asset class.

Credit

Alternative investments offer low correlation with stock and bond markets, making them valuable tools for portfolio diversification. They may also serve as inflation hedges as they often contain hard assets such as gold, oil and real estate.

However, alternative investments may be more complex and expensive than traditional securities. With higher minimum investment requirements, fees, transaction costs and less verifiable performance data for such investments than their traditional counterparts, you should consult your financial professional about whether these assets could fit within your overall investment goals.

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