‘Alternative’ Might Just Mean ‘Unfamiliar’

April 23, 2012

'Alternative' Might Just Mean 'Unfamiliar'

Once upon a time, the stock market was considered an “alternative” market.

In the late 19th and early 20th centuries, the stock market was a Wild West free-for-all where prudent investors feared to tread. Protective rules and regulations were virtually nonexistent, and what few there were went largely unenforced. Stock certificates could be stolen or forged. Pricing was usually shallow, opaque and thus vulnerable to extreme manipulation, especially by insiders who didn’t care about wiping out hundreds or thousands of investors. Realizing favorable returns by trading stocks demanded nerves of steel, and perhaps some aggressive arm-bending of one’s own.

Instead, “real” investors were almost exclusively focused on physical assets—buying and selling them, or lending against them in the form of bonds. Real property such as land, goods and equipment represented true wealth, and dealing in them one way or another was subject to fewer of the challenges that plagued the stock market. It would, for example, be impossible to forge a shipment of oil, and land was about as permanent as things could be. Although such assets were far from perfect, they enjoyed reasonable liquidity and could be readily resold to other investors.

Today, of course, the situation has entirely reversed. Most investors assemble stock-centric portfolios, and everything other than stocks (and bonds) is classified as “alternatives.” This includes the same land, goods and equipment markets that had dominated the investment landscape a century or so ago.

The Rise Of Securities
How did this come to pass? Over time, it became clear that the efficiencies of scale accrued to the largest players, which were corporations. They could produce profits relatively quickly, making shares of ownership much livelier investment vehicles than were loans paid off at a plodding, fixed rate. Corporations used both stocks and bonds to raise capital, of course, but stocks were in the enviable position of being able to capture economic growth.

Naturally, the investors attracted to these wondrous instruments demanded legitimate market improvements and efficiencies: price transparency, trading technologies, securities clearing, regulatory oversight and so on. Ultimately, the stock market sufficiently addressed virtually all of the earlier challenges. It became the most liquid and transparent of investment markets.

The equities market’s very long, continuous and public track record allows it to become a readily accessible investment measure that permits investors everywhere to reference and analyze its data. Stocks have been transformed from investment outcasts to being the “devil you know.” Almost everything else—the catchall definition of “alternatives” —has become the devil that most investors don’t know.

And this devil’s name is “risk.” What are our chances of losing money? Do we know how we could be rewarded? Do we understand the economics of the investment marketplace?

The devil-you-know moniker for stocks is relative, of course, since we cannot have perfect knowledge and each new cycle seems to bring an event that breaks old expectations: the 1987 crash, the Internet bubble, the 2008 financial crisis and the “lost decade.”

Prospect Theory
An interesting model for something as basic as defining alternatives as “alternatives” might be “prospect theory,” which was developed and published by Daniel Kahneman and Amos Tversky in 1979. In their paper, they demonstrated that individuals (and investors) are risk-averse and therefore do not always make rational decisions in which they opt for the highest expected value outcome.

In today’s investment environment, in which stocks are widely and easily available, the default decision is to opt for stocks, whose risks are largely known. An alternative-investment option—whether commodities, real estate, managed futures or anything else—may be a desirable addition to a portfolio from an economic perspective, but the risks are less known and therefore more threatening.

Stated differently, the relative predictability of stock risk is favored over the uncertainty surrounding the risk in alternatives, even if the portfolio outcome is suboptimal. Of course, this is not to imply that stocks are more legitimate than “alternatives” and other investment options. Rather, the default preference for stocks can be partly explained by the time and expense required, whether spent directly or through advisors, for coming to understand alternatives and their associated risks. It is not a trivial task.

For example, contrast stocks with commodities. There are large and small stocks, growth and value stocks and lots of sectors—but they are all stocks, and a major market move can sweep most of them higher or lower regardless of whether they individually deserve to be so repositioned. They are a true asset class, a cohesive grouping of securities that usually react similarly to economic cycles and that have many other common characteristics.

But beware of transposing this asset-class attitude to commodities. There is no singular commodities market. There are, instead, commodity markets. Each one is driven by its own supply and demand factors, which can be radically different from one to another—even when the commodities themselves are related, such as crude oil, gasoline and heating oil. Stock-oriented investors almost always got burned when venturing into commodity markets because of this diversity.

Until, that is, the advent of diversified commodity indexes led to investment vehicles that bundled these individual, disparate markets into one price. Then the floodgates opened, and some $200 billion to $300 billion has flowed into commodity funds, notes and other investment vehicles over the past 20 years because the complicated was magically rendered simple. Or so it seemed.

Underneath, though, commodities are still the churlish individualists they always have been. Just ask the immigrated investors who have reluctantly expanded their “price-earnings” vocabularies to include “Brent” and “WTI,” not to mention “contango” and “backwardation.”

Perhaps the time will come when the now-murky risks of commodities, commercial real estate, timberlands and even vintage wines also will be “known devils.” Until then, the alternatives bucket will continue to seduce some investors and repel others with mysterious booms and busts.

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