Alternative investments like private equity, hedge funds, managed futures and real estate can provide excellent diversification benefits to an investment portfolio. However, due to their complex nature, lack of regulation and high costs, allocating too much capital to alternative investments can be risky. Following proper alternative investment concentration guidelines helps mitigate risks and maximize rewards.
Limit overall alternative investment allocation to 20-30% of portfolio
Most financial advisors recommend limiting alternative investment allocation to 20-30% of total portfolio value. This ensures adequate diversification and limits downside risk. Within this range, most advisors suggest a 10-15% allocation to private equity, a 5-10% allocation to hedge funds, a 5% allocation to managed futures, and a 5% allocation to real estate.
Diversify across alternative investment strategies and asset classes
Rather than investing in a single private equity fund or hedge fund, diversify across different strategies, managers and geographic regions to minimize correlated risks. For instance, allocate to value stocks, growth stocks, market neutral and global macro hedge funds. Similarly, diversify real estate across commercial, residential, REITs, and international.
Maintain sufficient liquidity for emergencies
Most alternative investments have lengthy lock-up periods, so maintain adequate liquidity in stocks, bonds and cash to meet any unexpected needs. Aim to have at least 6 months of living expenses in cash savings.
Invest only long-term capital
Given the illiquid nature of alternatives, invest only long-term capital that you don’t expect to need for at least 5-10 years. Avoid allocating short-term savings that may be needed unexpectedly.
Rebalance portfolio allocation regularly
As alternative investments appreciate over time, they may come to represent too high a percentage of total portfolio value. Rebalance periodically by taking profits and reducing alternative investment allocation back to the target percentage.
Following prudent alternative investment concentration guidelines helps build a diversified portfolio positioned for long-term growth. Limit overall allocation, diversify across strategies, maintain liquidity, invest long-term capital and rebalance regularly.