How to Diversify Into Alternative Investments

(This article appeared previously on MarketWatch.com.)

Reluctant to put more of your hard-earned money aboard the roller coaster known as the stock market? Then it may be a good idea to diversify your retirement savings with other assets, which can reduce your overall risk.

1. Real Estate

Real-estate investments can provide solid income each month, tax deductions for such things as depreciation and mortgage interest, and the potential to build up equity in a property.

Risks include tenants who don't pay rent on time (or at all), forcing you to make the mortgage payment and cover expenses out of pocket. Tenants also can damage your property.

Real estate is also a fairly illiquid asset, meaning it cannot be sold quickly if you need to get your capital out.

Finally, real estate requires a large upfront investment, as lenders tend to require at least 20 percent down for a purchase, plus closing costs (typically 2 percent to 5 percent of the purchase price). Hiring a property manager will likely cost you 8 percent to 12 percent of the monthly rent , unless you have the time and patience to be a landlord yourself.

“There's a lot of risk involved in it,” says Guy Baker, a certified financial planner based in Irvine, Calif. “It's one of those things that if you have experience in that business and you understand it well and can really be confident in your decision-making ability, it can probably work, but most people aren't like that.”

(MORE: Make Your Money Last Your Lifetime)
 

2. Peer-to-Peer Lending

Peer-to-peer (P2P) lending is a relatively new way to invest. It works like this: You create an account at a P2P website (such as Prosper or Lending Club), transfer money to the account, and begin investing in personal loans. As borrowers pay back the loans, you get your principal back plus interest (minus fees), which can provide a steady income stream and a solid return on your investment.

How much money can you make? At Prosper, the actual return on all loans from July 2009 to November 2013 was 9.3 percent annually; returns at Lending Club are similar, with median net annualized returns of 8.5 percent.

The biggest risk is default — the borrower not repaying the loan. These are unsecured loans that aren't backed by collateral, so you probably won't recoup any of your investment in the event of a default. To limit this risk, you can invest as little as $25 down for each loan on both Prosper and Lending Club, spreading out your risk.

For example, by investing $25 in each of 200 loans, a single default would have much less of a negative effect on your returns than if you lent money to just two or three borrowers. You can also choose to lend money to borrowers with better credit scores and higher income levels, although your return will be lower.

3. Precious Metals

Gold and silver are regarded as a hedge against inflation and economic uncertainty, meaning that their price tends to rise amid these conditions, when other investments suffer. Gold and silver are also highly liquid, which means they can easily be converted to cash.

Alternatively, you can buy shares of an exchange-traded fund that seeks to replicate the performance of a precious metal, such as the SPDR Gold Shares, or the iShares Silver Trust.

There are a few drawbacks to be aware of. Gold and silver are highly volatile, which means they can experience unpredictable and wild fluctuations in price. Gold, for example, rose from $500 an ounce in 2006 to record highs of $1,900 an ounce in 2011, only to fall back to the current price of around $1,200. Silver was even more volatile, rising from $10 an ounce in 2006 to $40 in 2011, only to tumble back to the current price under $16.50.

Gold and silver don't generate any income. The only way you make money off a precious metal is by selling it for a higher price than you paid for it. This makes it a riskier retirement investment, since most retirees need income to live on.

“Gold is speculation — it's just reflective of the value of the underlying currency of the economy,” Baker says. “When it went way up in value, it was because everyone lost confidence in the dollar, but as soon as the value of the dollar came back, the price of gold went back down ... so the people who bought in late lost substantial.”

Cliff N. Goldstein is a member of the personal finance team at NerdWallet, an unbiased source of tools and information aimed at helping consumers make smarter financial decisions. He previously worked as a financial investment professional in the Private Wealth Management division at Goldman Sach. Follow Cliff on Twitter @CliffNerdWallet.

By MarketWatch