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Alternative Investments for the Advanced Investor Only

There are many alternative investments besides the standard stocks and bonds; however most of them are for advanced investors or those who employ investment advisors. Such investments would include, but are not limited to, short sales, options, collectibles, real estate, managed futures funds, and funds that use derivatives.

“All investors should have a basic understanding of what these advanced investment strategies are so they realize why the alternatives may not be appropriate for them,” says Pat Swanson, CFP® and families specialist with Iowa State University (ISU) Extension’s Invest Wisely Project (www.extension.iastate.edu/investwisely).

Short sales are sales of a stock with the expectation it will decrease in value. If the opposite occurs the transaction will result in a loss and there is not an upper limit to the amount an investor can lose. “When you make a short sale a broker uses the stock from his or her inventory to deliver to the buyer, so the investor borrows the stock from the broker,” Swanson explains. “When the short sale is covered (the investor pays the broker for the security loaned to him or her) the transaction is complete.”

What is called a covered short is when investors hold the stock they are selling. In such cases the investor is attempting to hold on to any gains realized until the time of the sale without selling the underlying security. This method is also called hedging.

Options are of two types, calls and puts. If you expect a stock to go up you would buy a call. If you expect a stock to go down in price you would buy a put. “As an example, if you expected Widgets, Inc. to increase in price from its current price of $50 you might buy a $55 call at a price of $4. In such a case the buyer of the call would not break even until the stock reached $59 a share ($55 + the $4 call),” Swanson says.

Puts are purchased when you expect a stock to go down and the same type of arithmetic in the other direction would result. “With calls and puts your loss is limited to the amount paid for the call or put, which is an advantage over short sales,” Swanson says. “Another advantage of using calls and puts is that much less money is required to cover stocks than if the stocks themselves were bought or sold. But you can see, only experienced individuals should enter this arena.”

Collectibles such as gold often are touted as the next great investment but buying gold itself involves storage costs. In purchasing gold, investors should remember that gold doesn’t produce any income as do stocks or bonds. Therefore unless the gold appreciates and is sold, the investor doesn’t realize a return. “If interested in gold, most investment advisors recommend buying stock in gold mining firms rather than gold itself,’ Swanson says. While gold offers some protection against the declining value of the dollar, most advisors suggest that investors should not overload their portfolio with gold stocks.

You can invest in real estate either through owning real estate, such as your home, owning rental units, or investing in REITs (real estate investment trusts). “Despite the current down turn in the housing market, owning a home is probably the best long-term investment you can make because it gives more of a secure feeling than renting and interest paid on a mortgage is deductible on your tax return if you itemize,” Swanson says.

Rental units may be a good investment if you are handy and can do most of the maintenance and repairs that such units require. If all of these types of problems have to be done by others, rental returns may be severely diminished. A REIT is a security that sells like a stock on the major exchanges and invests in real estate through properties – e.g., shopping malls, office buildings, apartments, or hotels – or by purchasing or making funds available for mortgages. “Until recently many financial advisors considered REITs to be a good investment choice,” Swanson says. “However, due to the current problems with real estate, most REITs are probably not good investments until the real estate market settles down.”

Derivatives cover many types of investments. These are financial instruments whose value is derived from something else and they generally take the form of a contract. The main types are futures, forwards, options and swaps. Derivatives can be based on different types of assets such as commodities, equities, bonds, interest rates, exchange rates, or indexes. “The use of derivatives may carry a large amount of risk and therefore is not recommended for small investors and those who are not well informed,” Swanson says.

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The ISU Extension Invest Wisely Project provides a series of newspaper, radio, and web resources for investors.  It is funded by a grant from the Investor Protection Trust (IPT).  The IPT is a nonprofit organization devoted to investor education.  Since 1993 the IPT has worked with the States to provide the independent, objective investor education needed by all Americans to make informed investment decisions.  www.investorprotection.org.

 

 

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Updated December 19, 2007