Often, pre-retirees and retirees begin to invest more conservatively as they age. The general idea is that as their earning power diminishes once they are out of the workforce, it is sensible to scale back on riskier investments to prevent unexpected or drastic losses.
Yet, some older investors perceive alternatives as a way to diversify their portfolio and potentially seek higher returns or income. Before taking the jump into alternative investments, take these steps to make sure they are the right choice for your portfolio.
Consider your age, employment situation and savings. If you are still in the workforce, factor in how many years you have until retirement and calculate what your nest egg will look like. Ask yourself if you plan to work part-time in retirement, what your desired lifestyle looks like, and whether or not it is attainable given your expected savings.
[See: 6 Strategies to Avoid Working in Retirement.]
If you have already officially retired, ensure you haven’t taken on any debt and evaluate whether your lifestyle is sustainable given your retirement savings. If your expected or accumulated wealth isn’t sufficient, resist the temptation to chase higher returns and instead focus on how to invest your money safely.
On the other hand, if your long-term investing strategy has paid off and you have built significant wealth that is more than enough to support your lifestyle, you may have the capacity to take more risk with your investments.
Stay true to your risk propensity. Even if you have achieved financial success and have a solid plan in place (which may suggest you have a higher risk capacity, or ability to take on risk), you may not be comfortable taking on an inordinate amount of risk (meaning you have a lower risk propensity, or willingness to confront the possibility of a loss).
Make sure you have a complete understanding of your risk tolerance and monitor its alignment with your portfolio. Speaking with your financial advisor regularly will help ensure that your portfolio is designed to achieve your individual financial goals.
Once these steps are taken, you’ll have a better idea if any of the various types of alternatives would make sense for your personal circumstances.
[See: 13 Ways to Take the Emotions Out of Investing.]
Look under the hood. If all of these factors are considered and you and your financial advisor agree that investing in alternatives could be a strategic choice for your portfolio, make sure you do thorough research into aspects such as the following:
— Liquidity: Alternatives such as private equity and real estate investment trusts lack liquidity, which means the holdings can’t be quickly bought or sold, and oftentimes there is a period of time when your money is “locked up,” regardless if you want to sell it. This time horizon can be a major issue particularly for older investors. If you do choose to invest in illiquid alternatives, make sure you have enough liquid assets in case of an emergency.
— Volatility: Make sure you can stomach the volatility, or the amount of uncertainty about potentially substantial fluctuation in value, of alternatives like gold and commodities. Include these in your portfolio only if you have a strategic rationale, and work to study and understand them first.
— Valuation: Illiquid alternative assets are not publicly traded and priced, so it is difficult to determine what a true fair value of the asset is. Additionally, any pricing that is provided by the alternative asset company is delayed (they are normally priced with a month or quarter-end value).
— Fees: Management fees are higher for many alternative investments. Make sure you understand the structure and decide whether it affects your perceived value of the investment. For example, hedge funds traditionally charge 2 percent of total asset value and 20 percent of profits earned, which is much higher than what financial advisors and mutual funds charge. Additionally, many custodians charge an annual fee to hold alternative investments in order to offset the cost of additional certifications that they are required to have in order to custody illiquid assets.
Work with a financial advisor you trust. Too many Americans have been swindled by financial professionals who are looking to earn high commissions by selling investments that may be extremely unsuitable for their clients. Although the industry considers an individual with $1 million or more in assets to be an accredited investor, this does not mean that it is always appropriate to put him or her into hedge funds, private equity, or other alternatives that may be illiquid or associated with high fees.
Make sure you are working with an advisor who will transparently provide information on not only liquidity and fees, but other factors such as volatility, returns and taxes. You should also feel comfortable asking them if they are a fiduciary and how they are paid. If they are hesitant to answer or provide a convoluted or disingenuous response, consider taking your money elsewhere.
Alternatives are not all made equal, and as such shouldn’t be considered “good” or “bad” investments. As with any financial decision, it is important to first consider the rationale, pros and cons, and alignment with your risk tolerance and overall portfolio before making any investment.
[See: 10 Questions to Ask Before You Hire a Financial Advisor.]
Doing your research and consulting with a trustworthy financial professional will help you make a sound judgment that will both protect your money and keep your mind at ease.
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Alternative Investments Aren’t For Everyone originally appeared on usnews.com
