10 Speculating in Alternative Investments

Learning Objectives

  • Define and describe the characteristics of investment alternatives.
  • Understand the characteristics of these alternatives that make them speculative as investments.

Cryptocurrency

You can hardly go online or catch the news without hearing about cryptocurrency. While there are various definitions of cryptocurrency, here are some characteristics that they have in common (Hayes, 2023):

  • They are digital or virtual money that is issued in units called “coins” or “tokens.”
  • Coins are created and processed using encryption for security and verification.
  • Cryptocurrencies are decentralized, meaning no single person or group has control.
  • Most were created to operate outside of governmental oversight; however, this aspect is now being questioned as more and more people own cryptocurrency and, thus, are exposed to its risks.

Bitcoin is the most widely held cryptocurrency in the world. Watch this short video for background on how Bitcoin and the blockchain work.

Not surprisingly, this new form of currency has taken some twists and turns as it has developed, showing us both its positive and negative effects (Bitcoin, n.d.). These may apply to other cryptocurrencies as well.

PROs of Bitcoin

  1. Transparency: All Bitcoin transactions are public, traceable, and permanently stored in the Bitcoin blockchain network. Anyone can see the balance and all transactions of any address on this public ledger.
  2. Decentralized, peer-to-peer: The blockchain functions in a decentralized way so that no single person or group has control—rather, all users collectively retain control.
  3. Potential for Privacy: Traditional banking requires proof of identity while Bitcoin uses pseudonyms (more specifically, your wallet address) to execute transactions, giving users the ability to send money without giving identifying information. However, because all transactions are public, if someone figures out your unique pseudonym, they can also see your transactions.
  4. Accessibility and liquidity: Bitcoin provides global accessibility. It allows any business or individual to  securely send and receive payments anywhere at any time, with or without a bank account.

CONs of Bitcoin

  1. Volatility: At the start of 2021, Bitcoin was trading below $30,000 but suddenly started peaking in February and by April, it had almost doubled. Later that month, it crashed to its January level. Its recovery started in June and by August, it had crossed $50,000. After more ups and downs, it hit an all-time high of $68,521 on 11/5/21.

Look it up: What is the price of Bitcoin today?

  1. No Government Regulations: Many crypto enthusiasts believe having no government regulation is a PRO. It sets cryptocurrency apart from the traditional financial sector and banking world; however, this absence of regulation may soon be changing as lawmakers and regulatory agencies around the world consider taking action. The lack of regulation also means that there’s no equivalent to the Federal Deposit Insurance Corporation (FDIC) that would cover losses in your cryptocurrency account, as it does with a bank account in cases of bank failure. FDIC insurance guarantees up to $250,000 per depositor, per insured bank. Cryptocurrencies have no such guarantee.
  1. Irreversible: Unlike traditional bank transactions, Bitcoin does not allow transaction reversibility, aka “chargebacks.” In situations where you’ve accidentally sent funds to an incorrect unknown Bitcoin address, it is nearly impossible to recover your funds. If your assets are stolen, you’re out of luck!
  1. Limited use and lack of scalability: There is limited capacity to handle large amounts of transaction data on the Bitcoin blockchain network in a short span of time. Increasing trade volume causes a backlog which limits Bitcoin use because if we all transacted in Bitcoin daily, it would cause massive congestion to the network and fees would spike. Many experts, therefore, now view Bitcoin as a store of value rather than as a currency.
  1. Bad for the environment: The Bitcoin network uses astonishing amounts of electricity. Bitcoin miners require highly specialized machines to perform complex math calculations quickly and enough cooling power to keep the constantly running hardware from overheating. The process of creating Bitcoin consumes more electricity annually than all of Argentina!

But Bitcoin is not the only cryptocurrency out there. As of August 2023, there were 9,321 different cryptocurrencies worldwide (Statista, 2023).

Watch the brief video on “Altcoins” at the begining of the article on “10 important cryptocurrencies other than Bitcoin” (Hayes, 2023).

Cryptocurrency values can swing largely and quickly, which makes it frustrating to use crypto when making purchases. Let’s say that your favorite taco meal deal is selling for $5. If you’re paying with U.S. dollars, it does not matter if you buy the taco deal on Monday or Thursday—it will cost $5. But if you could also purchase the meal deal using cryptocurrency, you wouldn’t know how much it would cost you. For example, if there were a cryptocurrency of which 2 coins = $5 today, then you could buy the taco meal deal for 2 of those coins today. But due to fluctuations in the price of digital currencies, that same taco deal might cost you 2.42 crypto coins (= $6.05) three days later and 1.90 coins (= $4.75) a week later … and you might not know the price until it came time to pay.

Read an article on all the factors that influence the price of Bitcoin, the world’s most popular cryptocurrency (Bloomenthal, 2023).

Finally, keep in mind that the world of cryptocurrency moves quickly. Just within the past 12 months of writing this chapter in June 2023, major crypto exchanges have gone bankrupt (FTX) or are under investigation for mishandling customer funds (Binance). As an investor, it’s up to you to do your research and keep up with developments. The Wall Street Journal and The New York Times are valuable sources of up-to-date information; some schools offer their students and faculty free online subscriptions – check with your library.

Activity

How much do you know about cryptocurrency? Take the Crypto Literacy Quiz to see if you can pass. In 2022, only 9% of quiz takers scored over 60%.

Real Estate

When you buy a home, even with a mortgage, you are making a direct investment, because you are both the investor and the owner who holds legal title to the property. For most people, a home is the single largest investment they ever make.

As an investor, you may want to include other real estate holdings in your portfolio, most likely as an indirect investment in which you invest in an entity that owns and manages real estate.

Direct Investments

Sonia is looking to buy her first home. After graduating from college, she decided to stay on because she liked the town and found a job as an elementary school teacher. She loves her job, but her income is limited. She finds a nice, two-family house in a neighborhood close to the college. It needs some work, but she figures she can use the summer months to fix it up—she’s pretty handy—and renting to students won’t be a problem. The tenants will pay their own utilities. Sonia figures that the rental income will help pay her mortgage, insurance, and taxes, and that after the mortgage is paid off, it will provide a nice extra income.

Who doesn’t want a bargain? If you are handy with home repair and maintenance, a fixer-upper might just be the best way to begin building your real estate empire. Concentrate on smaller properties first. One strategy is to buy a duplex or triplex and live in one of the units. That way, you will know if any tenants are having wild parties at 2:00 a.m.

This is an example of direct investment—you buy the house (the investment). You own the real estate directly.

Depending on where you’re looking to buy, you may be able to find low down payments and seller financing of rundown properties. The seller may want to rid themselves of the chore of being a landlord. Use the services of a competent real estate attorney to ensure that all the documentation is correct. One issue with rundown properties is that banks and credit unions usually do not want to loan to distressed properties; however, banks and credit unions are usually more motivated to finance a rundown property that the bank had to foreclose on and is now stuck owning. In any event, do not expect your sojourn into flipping homes to be anything like the reality television shows.

You’ll also need to consider whether or not to hire a property manager. Some investors may want to take advantage of the services of a competent and reputable property manager, but the hard truth is that nobody cares about your property as much as you do, and fees for a property management firm can run to 10%, or more, of the rent. Keep in mind, though, that landlords must be savvy in dealing with a toilet and dealing with a tenant. If you are not handy dealing with both, then a property management firm might be worth the expense.

Many real estate investors begin like Sonia, buying a rental property that helps them to afford their own home. If you actively manage the rental property, there are tax benefits as well. Of course, you have to provide maintenance services and arrange for repairs, and, in Sonia’s case, perhaps give up a bit of privacy. In both cases, the investor is making a direct investment in the property.

The advantages to a direct investment are the additional rental income and tax benefits. The disadvantages are that real estate is relatively illiquid, and the investment concentrates your portfolio in one asset class—residential real estate. Conventional wisdom was that real estate was a good hedge against inflation, but recent price run-ups and the price falls that follow them have cast a shadow on that thinking. Also, to realize the tax benefits, you must actively manage the rental property, and being a landlord is not for everyone.

For the typical individual or couple homeowners, their home is their major asset. A home offers a hedge against inflation and functions as one piece of your overall diversified investment portfolio, assuming that you are investing in stocks and bonds through individual choices or mutual funds. Traditionally, a home produces an after-inflation return of about 2.5 percent a year although in some areas, the return has been much higher. There are also generous tax benefits for homeowners, such as the ability to itemize deductions on your yearly income tax returns. However, some financial experts take the perspective that a house is your home first and an investment second.

(Paiano, n.d., Real estate)

 

Indirect Investments

Investors who want to add a real estate investment to their portfolio more often make an indirect investment. That is, they buy shares in an entity or group that owns and manages property.

A common form of indirect investing is a real estate investment trust (REIT)—a mutual fund of real estate holdings. You buy shares in the REIT, which may be privately held or publicly traded on an exchange similar to a mutual fund or ETF. The REIT is a fund invested in various commercial properties. Some REITs specialize, concentrating their investments in specific kinds of property, such as shopping malls, apartments, or vacation properties.

An equity REIT invests in property, while a mortgage REIT provides real estate financing. A hybrid REIT does both. REITs do for real estate what mutual funds do for other assets. They provide investors with a way to invest with more liquidity and diversity and with comparatively lower transaction costs.

 

Summary of Direct vs. Indirect Real Estate Investment

Direct Indirect
Do you own the property? Yes, welcome to the world of home ownership! No
How can you get money for your investment? Obtain a mortgage (but may be more difficult for fixer-upper houses) Fund it with money saved for that purpose
Can you live in your investment? Yes No
Can you rent out your investment? Yes, you are the landlord No
How can you make money (income) from your investment? Price appreciation when you sell the house. Also, monthly rent if you’re also a landlord Price appreciation when you sell shares. Also, REITs pay out regular dividends
What ongoing expenses do you have? Repairs, insurance, property taxes. Also mortgage interest, private mortgage insurance, and property management fees for rentals, as applicable Taxes on dividends, REIT management fees
What are the tax advantages of this type of property ownership? Several tax deductions and credits may be available to reduce your tax burden Possibility of lower tax rate on dividends and capital gains on sale of shares for a profit
How liquid (easy to sell) is this investment? Often not liquid—selling a house sometimes takes a long time Usually liquid

Collectibles and Unique Investments

a few pairs of colorful Nike Mercurial Vapor Superfly and Nike Mercurial Vapor Superfly II shoes
Nike Mercurial Vapor Superfly and Nike Mercurial Vapor Superfly II different colorways collection. (CC BY-SA)

Any asset that is tradable may become an investment; that is, it may be purchased and held with the expectation that it can be sold when its value increases. So long as there is a market for it—a buyer—it potentially may be sold at a gain.

Examples of collectibles and unique investments include:

  • Sports trading cards and memorabilia
  • Rare books
  • Vintage clothes
  • Sneakers
  • Vintage vinyl
  • Antiques
  • Fine art
  • Musical instruments
  • Jewelry
  • Historical curios

As investments, collectibles cannot be standardized in the way that stocks, bonds, or even real estate and used cars can. Each asset has attributes that make it more or less valuable, even among similar assets. Its value is hard to judge, and therefore it is harder for buyer and seller to agree on a price.

Professional appraisers are knowledgeable about both the item and the market and are trained to evaluate such assets. Theirs is a better-educated guess, but it is still just an estimate of value. Individual investors also consult books on collectibles and may purchase professional market research, pricing indexes, and auction records.

Sometimes one person’s trash is another person’s treasure. It is fun to think that you may unearth a rare “find” at a garage sale or flea market or that some family heirloom has more than sentimental value. Usually, however, your ability to cash in on your luck is limited by your ability to convince someone else of its worth and to sell when its market is trendy.

Collectibles, including “ephemera” such as antique letters and photographs, are usually sold by dealers or collectors or through a private sale arranged between buyer and seller. Dealers may establish a gallery to showcase items for sale. Auction houses such as Christie’s or Sotheby’s organize auctions of many items or “lots” to attract buyers and provide catalogues with details on the items for sale, such as their “provenance” or ownership history.

The advantage of unique assets as investments is that you may enjoy collecting and having the items as well as watching their value appreciate. If you are a guitarist, for example, having and being able to play a vintage guitar may mean more to you than the fact that it may be a good investment. For some, collecting becomes a hobby.

The disadvantages of investing in collectibles are:

  • high probability of mispricing, as markets are inefficient.
  • lack of liquidity (how quickly an asset can be sold for cash).
  • lack of earnings, as there are no dividends or interest.
  • costs of holding the investment.

Unless you are knowledgeable about your item and its markets (and even if you are), it is common to suffer from mispricing. Collectibles markets are relatively inefficient because trading partners vary widely in their knowledge about pricing. Both buyers and sellers try to persuade each other of an asset’s rarity and value. It is easy to be misled and to make mistakes in this market. Online sales and auctions of collectibles at sites such as eBay may be fun for hobbyists, but they are not typically good venues for investors.

If you are trading through a dealer, you can check the dealer’s reputation through professional organizations, local business bureaus, and Internet blogs and websites, especially where customers can provide a rating or critique. You should also always try to find comparable items to compare prices. If feasible, get a second opinion from an independent appraiser. Knowledge is an important bargaining chip. The more you know, the more likely you are to be satisfied with your investment decision, even if you ultimately walk away from the deal.

Unique investments may not be readily saleable, or their markets may be subject to trends and fashions that cause price volatility. These characteristics mean that your investment may ultimately be a source of gain but that you cannot count on it as a source of liquidity. If you have foreseeable liquidity needs, it may not be appropriate to tie up your wealth in autographed baseballs, vintage action figures, or Navajo rugs.

There are no dividends or interest paid while you hold collectibles; so, if you have income needs, you should choose a more useful investment. There are also other costs, such as storage, security, maintenance, and insurance. Your investment actually returns a negative net cash flow—it costs you more than it brings in—until you realize its potential gain by selling it.

Collectibles can be a source of joy and a store of wealth, and you may realize a healthy return on your investment. In the meantime, however, they create costs so that, in order to make them a really worthwhile investment, your eventual return will have to be large enough to compensate for those costs.

(Saylor, 2012)

Gold (and Silver and Precious Metals)

Historically, gold and silver have been popular investments of individual investors. For thousands of years, gold and silver have been used as a basis for currency value, either minted into coins or used to back currency value. Most currencies used today are not backed by a precious metal but by the productivity and soundness of the economy that issues them. For example, the value of the U.S. dollar is not related to the value of an ounce of gold, but to the value of the U.S. economy.

When economic or political turmoil seems to threaten the health of an economy and hence the value of its currency, some investors choose to invest in gold or silver that seems to retain its value. For that reason, gold or silver has historically been regarded as a hedge against inflation. But is it? View the Two Cents video below to learn more.

(Saylor, 2012)

Commodities and Commodity Futures Contracts

a line graph highlighting the steady growth in dollars per pound of copper or bushel of corn, wheat, or soybean from 1960 through 2022. from highest to lowest value, the commodities are soybean, wheat, corn, and copper.

Some investors prefer to invest directly in the raw materials that are critical to an industry or market, rather than investing in the companies that use them by buying stock or bonds issued by those companies. Commodities are raw materials — agricultural products, metals, energy sources, and so on — that go into producing goods and services. Because commodities are–or rely on–natural resources, they have a largely unpredictable supply. They have inherent risk, because they are exposed to changes in weather or geology or global politics. Commodities trading is not new; the first commodities exchange in the United States was established in 1848.

But not everyone has the facilities to buy and store commodities in the amounts that they trade in – for example, tons of sugar or tens of thousands of pounds of cotton. Another way people and companies can invest in commodities is through a derivative known as a futures contract. A futures contract is a commitment to deliver a certain amount of a specified item at a specified date in the future. A futures contract buyer and a futures contract seller specify a commodity to be delivered and paid for when the contract matures. The futures price is guaranteed by the contract.

Producers of commodities use futures contracts extensively. For example, a wheat farmer in Iowa plants 1,000 acres of wheat in April. She knows that if all goes well, come September, she will have 500,000 bushels of wheat. September wheat futures are currently selling ‒ in April! ‒ for $6 per bushel. Our farmer can “sell” her wheat via a wheat futures contract while it is still germinating in the ground. She can guarantee a price that she is happy with and will result in a profit for her. The contract states she will deliver the wheat in September and receive $6 per bushel no matter what happens to wheat prices.

Consumers of commodities also use futures contracts. For example, cereal companies such as Kellogg’s, General Mills, and Post need tons and tons of wheat each year to make cereal and other foodstuffs. Via futures contracts, in April they can purchase the wheat to be delivered in September and pay $6 per bushel no matter what happens to wheat prices. In this way, we can think of futures contracts as insurance. The farmer and the food companies are using futures contracts like insurance to protect themselves — or hedge — against unfavorable changes in the price of wheat, in this case.

What are the disadvantages of using futures contracts when you are the producer and when you are the consumer? If wheat prices plummet, the farmer is protected, yes, but on the other hand, if wheat prices rise substantially, the farmer cannot take advantage of the higher prices since she is already contractually obligated to sell her wheat for $6 per bushel. Likewise, although the food companies are protected against considerable price increases, if prices fell appreciably, they will not be able to take advantage of the lower prices since the food companies have already promised to pay the farmer $6 per bushel, no matter what happens to wheat prices.

However, someone does not have to be a commodities producer or consumer like the farmer or cereal companies to buy and sell futures contracts. Speculators can simply buy and sell the futures contracts without taking delivery of the commodity. A speculator can buy a contract for 500,000 bushels of wheat to be delivered in September even if they live in an apartment in Astoria and have never seen a farm! Speculating with futures contracts is accepting the futures price risk without owning the underlying commodity. Speculation is the opposite of hedging.

Futures speculation depends on accurately forecasting the direction of commodity price movements in the future. Can anyone accurately forecast the future? If our Astoria speculator sitting in her condo had purchased the futures contract for 500,000 bushels of wheat to be delivered in September, and wheat prices plummeted, she could potentially lose hundreds of thousands of dollars!

Investments in commodity futures contracts can be risky business. When you invest in derivatives like these, you are taking on the risk of both the contract and the asset that it depends on. Commodities investing is risky for individual investors also because professional commodity investors often take speculative positions, betting on the future price of derivatives without holding investments in the underlying commodities. Speculators can influence that future price, which, after all, is just the market’s consensus of what that price “should” be. For individual investors, the risks of commodities trading often outweigh the advantage of whatever diversification they bring to the portfolio. The Commodity Futures Trading Commission (CFTC) offers effective information and tools to help consumers avoid fraud, including checking that people and firms that solicit you to trade are registered with CFTC.

Futures contracts are financial instruments that actually have a valid reason for existence and are very important to our global economy for large-scale producers and users of commodities. However, for the vast majority of investors, they are extremely risky and dangerous and can turn an otherwise prudent, long-term investment portfolio into a pool of tears overnight. Remember, you are learning about these derivatives so that you will be protected against their siren calls of “get rich quick.”

(Paiano, n.d., Futures; Saylor, 2012)

References

Bitcoin pros and cons. (n.d.). [PowerPoint slides]. Next Gen Personal Finance. Retrieved August 23, 2023, from https://docs.google.com/presentation/d/1btrlRj5ToxI0Gv0-lP36RE3bCMIy0v2onZi_0nPqEyY

Bloomenthal, A. (2023, August 27). What determines Bitcoin’s price? Investopedia. https://www.investopedia.com/tech/what-determines-value-1-bitcoin/

Hayes, A. (2023, August 25). 10 important cryptocurrencies other than Bitcoin. Investopedia. https://www.investopedia.com/tech/most-important-cryptocurrencies-other-than-bitcoin/

Paiano, F. (n.d.). Futures contracts. In Introduction to investments (Chap. 13, Subsection 13.1). LibreTexts: Business. https://biz.libretexts.org/Bookshelves/Finance/Introduction_to_Investments_(Paiano)/05%3A_Chapter_5/13%3A_Futures_Contracts/13.01%3A_New_Page

Paiano, F. (n.d.). Real estate and Real Estate Investment Trusts (REITs). In Introduction to investments (Chap. 17, Subsection 17.1). LibreTexts: Business.  https://biz.libretexts.org/Bookshelves/Finance/Introduction_to_Investments_(Paiano)/New_Page/Chapter_17%3A_Real_Estate_and_Real_Estate_Investment_Trusts_(REITs)/16.01%3A_New_Page 

Saylor Academy. (2012). Commodities and collectibles. In Personal finance (Sect. 17.3). https://saylordotorg.github.io/text_personal-finance/s21-03-commodities-and-collectibles.html

Statista. (2023, August). Number of cryptocurrencies worldwide from 2013 to August 2023. https://www.statista.com/statistics/863917/number-crypto-coins-tokens/