When market volatility is high, it is easy to lose focus of financial goals and react to the ups and downs of the stock market. While it is well known that investors should wait it out during periods of high market volatility, statistics show that investors make impulsive decisions during market downturns. A CNNMoney piece showed how investors, spooked by common concerns and backing away from the table, made the Dow drop 1000 points in early trading.
One type of alternative investment opportunity, asset-based lending, is generally structured to help investors avoid the stock market roller coaster while protecting their principal balance and targeting lower principal risk and higher returns. These types of investment opportunities are typically secured by tangible collateral like properties, machinery, land, etc. Investors who are looking to minimize their risk of principal loss can invest in an asset-based opportunity to provide extra protection for their portfolios in times of market volatility.
Here are a few ways an investment protected by a tangible asset is different from an investment in the stock market:
Asset-Based Finance & Collateral
With an asset-based investment, the investor is making their investment based on the valuation of some held asset that the borrower has – and so, that asset acts as collateral. For example, if a company has bought a new piece of equipment at the cost of $75,000, it can borrow against that asset. The investing instrument created by this agreement, whether it’s a bond or some other form of financing, is backed by that collateral, which means that in a default situation the asset would be sold to repay the principal. In the case of real estate, a first lien position on a property mortgage may act as collateral, and in the case of litigation finance, it will be a first lien position on the future proceeds from a settlement.
This idea of collateral is radically different from the stock market, where the investment is not protected from loss. Investors who put money in asset-based opportunities can sleep soundly knowing that their principal balance has some form of protection against principal losses.
Low Market Correlation
Market-correlated investments rise and fall with the stock market. Indicators like the Dow and the S&P accurately track the worth of these investments. That’s great when the market is up, but what about when it’s not? To really play it smart, investors sometimes have to “bet against the market.” They have to stay in the game when everyone else is running for the exits. Investors have too often relied on their intuition to achieve a return on invested capital within the stock market.
Alternative investments, on the other hand, have different volatility patterns than the stock market, or, in some cases, are completely disconnected from market volatility. For example, an investment in high-end real estate in New York City doesn’t fluctuate by the same indicators as real estate in other areas that are more sensitive to credit cycles. That’s because a row house in Detroit or Philadelphia or Dallas has a volatile value related to common property markets, but the value of a New York Skyscraper is, in some ways, immutable. It’s part of a historic and cultural skyline that will hold value when other real estate investments are under pressure. Litigation finance, on the other hand, will perform regardless of whether the stock market is up or down. That is because as long as there are plaintiffs seeking funding, there will be pre-settlement funding companies, and litigation portfolios to invest in. Alternative investments like lawsuit loans and real estate are a valuable way for investors to diversify outside of the stock market for a potentially more stable and consistent income source.
Asset-based finance investments can also be a great way to diversify an investor’s portfolio by evening out a portfolio’s performance with different types of alternative assets. Modern Portfolio Theory teaches us that one way to minimize portfolio risk is by building a portfolio of assets that are not correlated amongst themselves, meaning when opportunity A is underperforming, opportunity B will be performing well, and opportunity C will be on course, etc. That way, no one investment opportunity will be able to swing the portfolio to underperform, instead of evening out the overall performance and yield. In fact, when looking at the performance of diversified portfolios, we often see that they outperform a concentrated portfolio during market downturns.
The nature of asset-backed alternative investments makes it easy to diversify between asset types, geographies, and durations. The performance of a real estate opportunity may depend on the composition of the portfolio ranging in type of development (commercial vs. residential vs. mixed use), real estate geography (metro area vs. suburban), and loan to value (LTV) ratio. Investors can balance their overall investment portfolio between differently performing properties to fill performance gaps or lessen risk.
Investing with the Pros
Beginner investors who are still learning the ropes of choosing what opportunity to put their capital in may benefit from another factor that separates asset-backed investments from stocks. Because there is a certain degree of risk associated with debt investments, originators do their best to perform multiple rounds of due diligence before offering an opportunity to investors. In many cases, the originator retains some portion of the investment opportunity for their own portfolio, investing their own capital alongside a group of investors. Unlike the stock market, where any investor can put money into any stock, asset-based investments have a certain degree of quality that can give investors – new and experienced, peace of mind when investing in alternatives.
Whether you are a new investor or an accredited investor with years of experience behind your back, it is important to note what types of opportunities are available to you and how they can play into your alternative investment portfolio. Alternative investments in asset-backed lending are very different from stocks in that they are backed by collateral, generally have a low stock market correlation, and are pre-vetted by professional originators. Depending on an individual investor’s financial goals and appetite for risk, alternative investments can prove to be a valuable addition to most investment portfolios.
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