Ep4. Alternative Investments
From real estate to cryptocurrency
Recently, so-called “alternative investment” appears frequently among investors. What is alternative investment? I want to introduce the alternative investment from the definition to wide spectrum. Alternative investment is not just a wide expansion of investment options, but has an important role for diversification, risk management, and improving long-term return rate.
Definition of alternative investment
Alternative investment is an asset class that is contrary to traditional investment such as stocks, bonds, and cash. It includes real estates, hedge funds, commodities, private equities, venture capitals, cryptocurrencies, and arts. It is attractive to investors with diversity and low correlation with traditional investment. These characteristics help to diversify risks and minimize influences about economic environment changes.
History of alternative investment
Its history is longer than we thought. People have invested in land, real estates, and arts for a long time. However, it was in the late 20th century that it was considered as an investment option. With the development of the global financial market, investors started to find a new method to achieve a higher return rate than traditional investment. In this time, various alternative investment options including hedge funds, private equities, and venture capitals arose and made a foundation of alternative investment.
Spectrum of alternative investment
Spectrum of alternative investment is wide. It has variety not just in investment options, but also in investment strategies, expected return rate, the level of risks, and market accessibility. For example, real estate provides stable profit and capital gain, but investors have to consider market volatility and maintenance. On the other hand, investment based on new technology like cryptocurrencies provides the possibility of a high profit but also brings high volatility and risks. Alternative investment itself offers options according to investment goals, risk tolerance, and market knowledge.
From now on, let’s look at various types of alternative investment and each characteristic in detail.
Real estate
▪️ Definition of real estate
Real estate investment is to invest in lands and buildings to earn profit. It includes residential real estate, commercial real estate, and lands. Investors invest in real estate buying it directly or buying REITs and stock or bonds related to real estate.
▪️ History of real estate
Its history is closely related to human history. People have used lands for survival and economic profit for a long time. Real estate investment in modern times develops with urbanization and industrialization. Its market became more professional from the 20th century and became a significant position in the financial market.
▪️ Characteristics of real estate
It has several unique characteristics. First, real estate is tangible so it assures stability to a point. Second, the investment earns profit from rental income and capital gain. Next, many countries offer tax advantages to real estate investments. The last one is that investors have to put effort and capital into maintenance. It is an expense of investment.
▪️ Features of real estate
Features of real estate have to be considered before you invest. The value of real estate increases in the long term because its volatility is relatively lower than others. Also, location of real estate is a critical factor to determine its value, so superior location can increase its value a lot. In addition, external factors such as economic fluctuation, policy changes, and natural disasters affect the real estate market. Investors have to consider this volatility. Last, real estate investment needs high investment capital at first, and it is a financial obstacle to access the market. Therefore, investors have to consider and understand those factors before investing.
▪️ Investment methods of real estate
There are several paths to invest in real estate, and each provides different merits for goals and situations. Direct investment is a traditional method purchasing a building and lending or developing it. Investors take direct control of the asset. On the other side, investing in REITs is an indirect method. Investors have an opportunity to invest in various real estate without the burden to manage each real estate asset. Investing in stocks or bonds related to real estate is a proper method for investors to earn profit from growth of the real estate market by providing capital to real estate development companies. Finally, crowdfunding is an innovative method to fund multiple investors using the internet. It offers to participate in a large project with small capital, lowers investment obstacles, and provides accessibility to real estate projects. Those various methods make investors customize portfolios considering their financial status, risk tolerance, and investment goals.
Foreign exchange
▪️ Definition of foreign exchange
Foreign exchange means trading currencies. It is one of the largest financial markets and is a market trading various currencies. Investors buy and sell currencies to earn profits using foreign exchange rate movement. Main participants of the market are a central bank, commercial banks, financial institutions, government, firms, and individual investors.
▪️ History of foreign exchange
Its history starts from the gold standard era. Foreign exchange market of modern times begins with the collapse of the Bretton Woods system. In this time, fixed foreign exchange rate was abolished, and the value of currencies was determined by supply and demand in the market. After that, the market has grown rapidly with technology development, improvement of communication, and globalization. Nowadays, it becomes a market having trillions of trading volume.
▪️ Characteristics of foreign exchange
The market is one of the most current markets, and investors can trade 24 hours except on weekends. It reflects that the market is global trading every currency and is affected by economic and political events. Also, investors use leverage to execute large trades with small capital, so it involves high profits and risks at the same time. These characteristics attract investors and make the market a crucial tool for investors to respond to economic fluctuation and to seek profits from value fluctuation among various currencies.
▪️ Features of foreign exchange
It provides lots of accessibility to investors using spot trade, futures trade, and swap trade. Those tools make investors utilize volatility of global markets and seek profits. Additionally, it supports investors to manage risks efficiently using stop-loss or limit order. From a market analysis perspective, investors use technical and fundamental analysis to forecast market trends and to construct strategies. Combining these factors, the foreign exchange market becomes the market with complex and attractive investment realm.
▪️ Investment methods of foreign exchange
There are various methods for foreign exchange, and investors choose it based on their investment preference and goals. The first one is a direct investment. It is a traditional method of buying and selling currencies by themselves. It is based on investors’ judgment and knowledge. The next is using brokers. Investors can ask advice from the brokers. The third is the auto-trading system. It automates market analysis and investment decisions using softwares. It minimizes investors’ participants and trades quickly. Each method has pros and cons, and investors choose it based on their investment style and goals.
Derivatives
▪️ Definition of derivatives
Derivatives are financial contracts that the value is determined by the value fluctuation of a certain asset. An asset here includes stocks, bonds, commodities, foreign exchanges, interest rate and et cetera. There are options, futures, forwards, and swap contracts. Those can be used to forecast the market, to hedge risks, and to speculate.
▪️ History of derivatives
Its history has continued for centuries. Early form of derivatives was a futures contract to prepare for price volatility of crops, and farmers used it to specify crops’ future price before they harvested. Modern derivatives have developed since the 1970s. Nowadays, it has a significant role to make complicated financial strategies and to manage risks.
▪️ Characteristics of derivatives
Derivatives have various characteristics and are used for diverse aims. First of all, derivatives are used for risk management, also known as hedging. It protects assets from market uncertainty and price volatility and manages risks. For example, exporting firms can protect their assets by using foreign exchange derivatives from foreign exchange risks. It also can be used for speculative purposes. Using high leverage, investors seek large profit with small capital, but also have to embrace high risks. Therefore, investors use it after they project price movement for speculative investment. In addition, derivatives increase market efficiency. It improves transparency of market information and contributes to finding a proper price. These features make derivatives important tools to find appropriate investment opportunities and to increase market efficiency. However, derivatives are complex, so it requires a high level of expertise and experience. Plus, financial authorities in countries manage and regulate the market to protect investors and to maintain market stability.
▪️ Types of derivatives
1. Option
An option is a remarkable type of derivatives. It is a right to buy or sell a certain asset whenever the owner wants to. To execute the right, investors pay “premium” as a cost for the option. There are 2 types of option contracts.
- Call option : a call option is a right to buy an asset and is chosen when the price is expected to increase. The owner of the call option has a right to buy the asset at a predetermined price in the future.
- Put option : a put option is a right to sell an asset and is chosen when the price is expected to decrease. The owner of the put option has a right to sell the asset at a predetermined price in the future.
▪️ Characteristics of options
Like we saw before, the option is a contract of right to buy or sell an asset in the future. It has 3 components ; expiration date, execution price, and premium. The expiration date is a date when the validity of the contract vanishes. The owner can execute the option before this date. The execution price is a price to trade the asset. It is a trading price when the owner buys or sells the asset through the contract. Also, the premium is a cost to buy the option. Those components define terms of option contracts and assign the right or responsibility to buy or sell the asset.
2. Futures
Futures is a contract to trade a certain asset at a specified price on the specified date. It provides an investment opportunity for investors to protect their assets from upcoming price fluctuation.
▪️Characteristics of futures
Futures contract expires on the predetermined date, and participants have to trade the asset at a predetermined price. It has a structure to make a contract beforehand and to deliver or receive the asset on the expiration date. Of course, from an investment perspective, participants don’t deliver or receive physical assets. They just give and receive investment profits. Also, the contract is usually standardized, which indicates trading volume, price unit, and expiration date are determined in advance. It makes market transparency increase and trades work. Additionally, a buyer has to pay initial margin and has to pay more if the value of the contract decreases lower than a certain level, called maintenance margin. This is a crucial factor to maintain trade stability. If the buyer doesn’t meet the margin, the position will be settled.
3.Forwards
Forwards is a contract similar to futures. The difference is that it is not standardized.
▪️Characteristics of forwards
Forwards contract is flexible because it is based on negotiation between participants. It means participants can make a contract using conditions and horizon they want. Plus, it is not standardized, so it can be constructed by participants’ needs. It has the same meaning that it can be customized. However, it is not protected, so there is market riss, especially counterparty risks which means a risk that a counterparty of the contract doesn’t perform obligations. Thus, investors have to consider whether it is valuable to invest even though they have to take the risk.
4. Swap
Swap is a contract to switch interest rate, currency, risks and et cetera. There are several types of swap.
- Interest rate swap : It is a contract to switch interest that each participant has to pay. It usually switches fixed interest and variable interest.
- Currency swap : It is a contract to switch 2 currencies. It is used by global firms, financial institutions, and governments.
- Credit swap : It is a contract to handle credit risk of debtors. It gives rewards when the debtor defaults.
There are more swap contracts including total return swap. Choosing a proper swap, investors can hedge future risks.
▪️Investment methods of derivatives
Investors can choose an appropriate investment method among lots of methods. First one is to invest directly. It requires investors to have knowledge and analysis skills. However, currently, it is banned. Investors have to use brokers. The next one is to use derivatives for hedging. For example, to decrease downward pressure of a stock portfolio, investors might purchase an option which bets on price decrease. Another method is speculation to seek profit through forecasting price movement. It targets a high return rate, but involves high risks as well. Finally, diversification is to invest in various derivatives to diversify risks. It offers stable profit.
Cryptocurrency
▪️Definition of cryptocurrency
A cryptocurrency is a virtual currency existing in a digital form. It uses enciphering technology to reinforce trade security, to control total volume of the currency, and to review the trade. It is dependent on a central authority and is recorded on a distributed ledger using blockchain technology.
▪️History of cryptocurrency
It began in 2009 with the emergence of Bitcoin. Bitcoin is the first cryptocurrency made by an anonymous programmer named Satoshi Nakamoto. After the success of Bitcoin, thousands of cryptocurrencies appear including Ethereum, Ripple and et cetera.
▪️Characteristics of cryptocurrency
It has unique characteristics. It is managed by every participant without any central authority. We call it decentralization. It is managed by blockchain technology. Second, anonymity means participants don’t need to show their information and real identity in public. Private information is protected even though transaction information is open. In addition, every transaction is recorded in public, so everyone can review the transaction. It guarantees transparent and safe trades. The last one is high security. It indicates every transaction is protected by a complex algorithm. It makes cryptocurrencies hard to forge or fabricate. These characteristics make cryptocurrencies an unique asset class.
▪️Features of cryptocurrency
The value of the cryptocurrency is too volatile. It might provide a possibility of high profits, but also involves high risks. Also, it is regulated severely. Many countries don’t have a clear regulation about the cryptocurrency, so investors have to confront uncertainty. Plus, it requires technological understanding and obstacles. Investors need to understand deeply about blockchain technology, and it might be an obstacle to some people.
▪️Investment methods of cryptocurrency
Investors can invest in the cryptocurrency directly using exchanges. It is universal. Also, investors can mine the currency by themselves using computers. Whenever you solve a problem, you receive the currency as a reward. If you don’t want either, you can invest in stocks or funds related to the currency. You can invest in cryptocurrency companies. You can participate in the industry growth at the same time. Finally, using funds related to the cryptocurrency is a good way. Those funds are managed by experts and provide various opportunities to invest in the cryptocurrency.
Other alternative investments
There are more kinds of alternative investments. There are arts, antiques, wines, or startup investment. Each has its unique features and investment strategies.
For example, investing in arts is to buy an art piece like paintings or sculptures. It targets not just to earn long-term profit, but also to improve cultural value. Investing in antiques is to invest in things having historical and artistics value. It is possible that the value increases as the time passes. Investing in wine also has the same context with investing in antiques. Investing in startups is to invest capital in the early stage of the company. Investors have to embrace high risk but take chances to earn tremendous profit.
Finishing the post, I want to reconfirm that those investments provide additional value to your portfolio. Those have different structure from traditional investments, and can be used for colorful strategies to achieve investment goals. Understanding each market’s trend and volatility leads you to succeed in investment. Before we finish, be careful when you invest in alternative investment because it requires continuous education, research, and sometimes advice from experts.
