Liquidity

• A major consideration for allocation to alternative investments is liquidity. Most stocks are highly liquid and high quality bonds even more so. An investment in venture capital, or real estate, however, is difficult to turn over quickly -- it's simply not as liquid. Therefore, an investor must realistically address their need for short term funds and weigh the possibilities against tying up money in potentially profitable, but longer-term alternative investments.
  
  

Risk and Return

• An incentive for allocating capital toward alternative investments is that they tend to offer a better risk/reward profile than the traditional asset classes. That is to say, a very safe investment usually earns very little, while a high-yielding asset often carries considerable risk of loss. While this generally remains true for alternative investments, the amount of reward -- capital gain -- is relatively high for the risk they pose. In part this is because alternative investments are much less volatile (think how slowly the value of a house changes compared with a stock). This low volatility minimizes the risk of short-term downward movements in price without preventing long-term appreciation.
  
  

Considerations

• Of course, there is no free lunch. Real estate prices do go down, and art can lose some of its value. A true picture of alternative investment risk considers many factors other than just historical prices. Macroeconomic forces such as inflation and deflation have a pronounced effect on historical data, but do not necessarily represent forward-looking risks accurately. Assets can be subject to global forces, as is usually the case with commodities, or, as often occurs with real estate, local forces. Private equity, the so-called "smart money," similarly escapes the drags of macro-level forces by identifying hidden value sooner than other capital streams. Anticipating how economic forces will act over the term of an investment is critical to effective asset allocation.
  
  

Allocation

• Ultimately, the goal of asset allocation is to maximize risk-adjusted return. In other words, to generate as much return as possible with as low a relative risk as can be managed. Diversification is an important strategic element in this pursuit, not just in asset class, but in risk. Alternative investments such as real estate and private equity, which have a low correlation with global market forces, tend to provide the best risk-adjusted return. Thus, a portfolio with 20 percent allocated to relatively illiquid alternative investments might favor real estate and private equity over commodities hedge funds simply for their relative insulation from larger economic trends and the effect this has on risk-adjusted return.