With stock and bond prices at relatively high levels, individual investors are turning increasingly to “alternative” investments.  Should you?

First, the answer: only if it’s a small portion of your investments, and only if your “alternatives” are diversified, low-fee and professionally managed.

Second, some background.  “Alternatives” are almost anything outside traditional stocks and bonds.  They include hedge funds, venture capital, private equity, commodities and real estate.  They include your neighbor’s business venture.  They typically have high fees.  They usually have a great story: the promise of high returns or low “correlation” to the market — meaning the investment may not drop with the market.  The Wall Street Journal reported “alternatives” mutual funds have $216 bn in investor funds, compared to $11 bn a decade ago.

Third, the reality.  While some alternatives may provide a hedge against market volatility, there is almost no evidence they provide higher returns.  Academic research on the largest and fastest growing alternative – hedge funds – concludes that, on average, they do worse than the stock market after their high fees and tax bills.  Previously available only to institutions, hedge funds are now aggressively marketing to individual investors.  Talk about a flashing yellow!

Finally, the caveat.  History suggests some alternatives may make sense.  Real estate and commodities may both zig when the market zags, and provide an inflation hedge. The leading venture capital funds seem to do very well … if you can get into them.  But alternatives are usually riskier than a traditional stock or bond mutual fund.  So limit the amount of your investment.  And when your neighbor wants to talk about his next business venture, offer instead to donate to his favorite charity.