When people think “investments,” they usually think of stocks and bonds, but these two options are just the tip of the iceberg. There are many alternative investments in the marketplace just waiting for investors to snap them up. However, some of these investments are obscure for a reason: They’re a bad choice for all but a very small subset of investors.
In investment terms, a commodity is a raw material that’s either used in its current form or as a component to build something else. Gold is the best-known and most popular as an investment, but many others exist, ranging from pork bellies to crude oil. There are three basic ways to invest in a commodity: buy a contract on the futures exchange, buy the commodity itself (e.g., physical gold bullion), or buy shares of an exchange-traded fund (ETF) or mutual fund that invests in the commodity, either directly or indirectly.
For the typical investor, the last option is the best and most practical one. Commodity mutual funds and ETFs are available through most brokers, and because they typically buy shares in several different companies that represent that commodity, you get a bit more diversification. Futures contracts are insanely risky: You are promising to buy a certain commodity at a certain price at some point in the future, which means you could easily lose your shirt if you guess wrong about where the commodity’s price will go. And while buying the commodity directly may be an option in some cases (for example, companies like Bullion Vault allow you to buy as little as a gram of gold at a time and will store the gold for you in secure vaults), in most cases, it doesn’t make much sense. You probably don’t want to buy barrels and barrels of crude oil and hang on to them in the hopes of price increase. That sort of operation is best left to organizations that can handle the transportation, storage, security, and so on.
Master limited partnerships (MLP)
A master limited partnership is a special kind of limited partnership that’s traded publicly, like a stock. In order to qualify as an MLP, the company must deal in certain approved businesses; the most common choice is natural resources (such as natural gas or oil pipelines). When you buy into an MLP, you’re actually becoming a partner in the company — though you’ll typically only get a limited partnerships, meaning you’re essentially a “silent partner” who doesn’t have a say in running the company.
These partnerships have no employees and don’t pay corporate taxes, so they can pass a larger percentage of the wealth to their partners than a traditionally organized corporation. Yields of 6% to 7% are common. MLPs come with significant tax drawbacks, though. Owning part of an MLP means that your taxes will get a lot more complicated. You’re responsible for paying your own share of the partnership’s income taxes, including state taxes (and if the MLP owns property in multiple states, figuring out what you owe to each state can get messy). Putting the MLP inside a tax-deferred retirement account can make things worse, as this income usually qualifies as unrelated business taxable income and is taxable despite the protection of the account.
Artwork, jewelry, stamps…the list of potential collectibles goes on and on. Many people buy such items simply for the thrill of the hunt and the pleasure of owning them, but others buy them as an investment, intending to hold the collectible until its value rises and then sell it. But collectibles of all kinds are extremely risky as investments because of the strong possibility that their value will fall. For example, consider artwork: Some paintings do indeed become incredibly valuable years or decades later, but the vast majority will never rise in value and may even fall based on the artist’s reputation. Tastes change, and the public’s appetite for certain collectibles is in constant flux. Also, there’s a serious tax drawback to collectibles: While most long-term investments benefit from a relatively low capital-gains tax rate, gains on collectibles are always taxed at 28%, no matter how long you hold them. This high tax rate will put a serious dent in any gains you managed to accrue on the collectible.
Finally, because collections are part of your personal property, they could be stolen or damaged in disasters such as fires and floods. Even if they’re insured, you’ll lose the potential to sell them at a profit down the road.
Diversifying with alternative investments
The biggest argument for choosing an alternative investment or two is that these investments tend to perform radically differently from the standard stock and bond options. For example, if the stock market is crashing and bonds are paying minuscule interest, gold is as likely to be climbing as falling. However, because alternative investments are typically more volatile and unpredictable than stocks and bonds, they should make up only a small percentage of your portfolio. If you carefully select some alternative investments to diversify a portfolio that mostly consists of stocks and bonds, they can actually decrease your risk instead of increasing it.