Rules of the Game: Not Worth the Risk

 | Sep 20, 2013 | 1:00 PM EDT
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One of the trade magazines that I regularly read is Investment News, or IN for short. It's a good publication, and one of its reporters recently interviewed me about emerging-market funds. (You can view the article here.)

But like any other news outlet, IN has to constantly come up with new ideas, fresh angles and -- above all -- new controversies and conflict to keep its audience interested. It's just the business model of media. I've written about it many times.

(Retail investors and traders should not worry that they are missing out on anything by not reading IN regularly. It's some pretty serious inside baseball when it comes to practice management for money managers. It's not really another source of "ideas" to add to the endless -- and I mean that -- stream of trading noise already out there.)

One of the events Investment News has been promoting heavily is its upcoming conference on alternative investments. Hedge funds, commodities, managed futures -- these all sound like a great ways to sidestep potential pitfalls of the stock market, using "non-correlated" vehicles.

The timing of the conference is perfect, as it coincides with the start of advertising by hedge funds, private equity funds and other non-traditional investment opportunities. As of Monday, the Securities and Exchange Commission's (SEC) ban on such ads will be lifted, and retail investors will be exposed to a barrage of new, exciting ways to play the old game of "beat the market." (The constant winners of that game, by the way, are Wall Street brokerages. The casino always wins – but it stays in business because hope springs eternal among people who think they have a secret formula that the rest of the world doesn't.)

Let's get real: Investing in alternatives sounds sophisticated, like a great scheme to outsmart those poor schlubs who are too stupid to understand anything beyond plain-vanilla stocks and bonds. And that lack of correlation makes a lot of sense, doesn't it?

Not really. There are some well-known problems with alternatives, such as hedge funds, private equity and commodities. I'll take a quick look at each.

Hedge funds, while seemingly exciting, are higher in cost than a basic, boring, diversified portfolio of stocks and bonds. They are often highly leveraged, less diversified and less liquid than just a plain old globally diversified portfolio. So the risk of having money trapped there is higher than in an index-based ETF or mutual fund.

Private equity and venture capital suffer from many of the same problems. In addition, the process is often very slow. It can take years for a private equity or venture capital company to invest in a company, work with management to either clean up the books or grow revenue, and then cash out. I know, the interest in "getting in early" is almost irresistible. But resist it. Notice how the examples are always of successes? "Why didn't I buy Apple (AAPL) in 1981?" Well, because you probably hadn't heard of it, and you wouldn't have believed its story back then, anyway. Substitute Wal-Mart (WMT) in 1972 or Microsoft (MSFT) in 1986. Same idea.

And it doesn't matter. People assume they would have been brilliant enough to buy the stock in its infancy, and then hold it right up until its peak, and sell at the right time. Nonsense. I know, there are those legendary stories of Great Aunt Pearl who bought 100 shares of General Electric (GE) in 1962, and the family inherited a windfall when she passed away. But that was just luck. It usually doesn't work out that way. (And in that example, Great Aunt Pearl didn't benefit anyway -- her heirs did.)

So you get my point about the folly of trying to get in early. Most of the time, that pot of gold fails to materialize, for a host of reasons.

Finally: Commodities. In the short term, gold, oil and gas, pork bellies, Wisconsin cheese futures -- any of them can be hedges against inflation.

But you still come back to a basic problem: In the short term, commodity prices can be extremely volatile, far outrunning volatility of the Consumer Price Index, which tends to move fairly slowly.

And here's another big issue: Commodities, whether you buy them through mutual funds, ETFs or futures, are, by nature, speculative. I know that gets those gambler juices flowing for many people, but that just tells you that any money put into commodities trades is "fun money." It's no different from what you set aside to bet at the blackjack table at the Bellagio.

There's also no need to take this extra risk. If you are already in a well-diversified portfolio, you will have exposure to mining, oil and agricultural companies. 

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