Alternative Investments: Basic Due Diligence Steps Before You Invest

Venturing beyond the familiar world of stocks and bonds into alternative investments can feel like stepping into uncharted territory. Things like real estate, cryptocurrency, private equity, or even collectibles are often touted for their potential to boost returns or diversify your portfolio. But before you jump in, it’s crucial to understand that these investments come with their own set of rules and risks. Just like you wouldn’t buy a car without checking its history or kick the tires, you need to do your homework – what we call “due diligence” – before investing in alternatives.

Think of due diligence as your investment safety check. It’s the process of investigating and verifying the details of an investment opportunity to make sure it’s legitimate, aligns with your goals, and that you understand what you’re getting into. Because alternative investments are often less regulated and less transparent than traditional investments, this step is even more critical. Imagine you’re considering investing in a local coffee shop. Due diligence would be like researching the coffee shop’s business plan, checking out their location, understanding their competition, and maybe even trying their coffee to see if it’s any good! With alternative investments, the process is similar, just applied to the specific type of asset.

So, what basic due diligence steps should you take? Here’s a breakdown to get you started:

1. Understand What You’re Actually Investing In: This sounds obvious, but it’s the most important step. Don’t just chase returns or buzzwords. Take the time to truly understand the alternative investment.

• What is it? Is it real estate, cryptocurrency, art, commodities, or something else? If it’s a fund, what types of assets does it hold? If it’s a business, what does the business do? If you can’t explain it simply, you probably don’t understand it well enough.
• How does it work? How does this investment generate returns? Where does the money come from? For example, with real estate, returns might come from rental income and property appreciation. For a cryptocurrency, it might be based on its technology adoption and market demand. Understand the underlying mechanics.
• What are the risks? Every investment has risks, but alternatives often carry unique and potentially higher risks. Is it illiquid (hard to sell quickly)? Is it volatile (price can swing dramatically)? Is it subject to specific regulatory risks? What could go wrong, and how badly could it impact your investment? Be especially wary of investments that promise “guaranteed” high returns – this is often a red flag.

2. Research the Investment Provider or Manager: Who is offering this investment? Their reputation and experience are crucial.

• Who are they? Are they a well-established firm or a brand new entity? Look them up online. Check their website, read reviews (if available), and see if they have a public track record. Be wary of anonymous or overly secretive providers.
• What is their experience and expertise? Do they have a history of successfully managing similar investments? Have they been through economic downturns? Look for transparency in their management team and their investment process.
• Are they regulated? Depending on the type of alternative investment, there might be regulatory bodies that oversee the providers. Check if they are registered or licensed appropriately. Regulation doesn’t eliminate risk, but it can offer some level of oversight and protection.

3. Examine the Fees and Costs: Alternative investments often come with higher fees than traditional investments. These fees can significantly eat into your returns.

• What are all the fees? Understand all the costs involved, including management fees, performance fees, transaction fees, and any other hidden charges. Ask for a clear and detailed breakdown of all fees.
• Are the fees reasonable? Compare the fees to similar alternative investments. High fees don’t necessarily mean it’s a bad investment, but they need to be justified by the potential returns and the value provided.

4. Consider Your Own Financial Situation and Goals: Is this investment actually right for you?

• Does it align with your investment goals? What are you trying to achieve with your investments? Does this alternative investment help you get there?
• Can you afford to lose money? Alternative investments can be riskier, and you could lose some or all of your investment. Only invest money you can afford to lose without jeopardizing your financial security.
• Does it fit your risk tolerance? Are you comfortable with the potential for price swings and the possibility of losing money? Be honest with yourself about your risk tolerance.

Performing basic due diligence might seem like extra work, but it’s essential for protecting yourself when venturing into alternative investments. By taking the time to understand what you’re investing in, who you’re investing with, and whether it’s truly right for you, you can make more informed decisions and increase your chances of success in the world of alternatives. Remember, in the realm of alternative investments, a healthy dose of skepticism and thorough research are your best allies.