Accredited Investor Installment #13: Closing Thoughts

[Editor’s Note:  Focusing on tangible investments, this is the thirteenth installment in a series of articles dedicated to the 95% of people in the U.S. who have never invested in a startup, a venture capital fund, a private equity fund or a hedge fund, even though they are permitted to do so, and even though doing so may make sense to achieve property diversification. Read Installments #1, #2 , #3, #4, #5, #6, #7, #8, #9, #10, #11 & #12.]

A Word About Risk, Liquidity and Illiquid Assets

A common misconception about illiquid assets (e.g., private equity, venture capital, hedge funds) is that they are more risky than more mainstream investments like stocks, bonds and mutual funds. This is false. It is true that most alternative assets are less liquid than mainstream investments, but this does not mean they are more risky. Liquidity and risk are separate concepts.

The very reason this series is addressed to the accredited investor, rather than to all investors, is that we use your status as a proxy. That is, we assume that if you have a high enough income or enough assets to meet the Federal Government’s definition of “accredited investor,” you already have a decent portfolio of investments, and your portfolio includes a sensible percentage of liquid assets.

The more liquid an asset is, generally speaking, the less of a return you can expect. This is a simple concept: money under your mattress is purely liquid, but it earns no interest at all (and, in fact, because of inflation, it loses value with each passing day). Money in a savings account is considered liquid as well, though the interest it earns is miniscule; agree to a six month CD, and the bank will pay you more interest; a year CD will get you even more.

But are any of these various investments riskier than another? No, of course not. In fact, it can be argued that keeping cash under your mattress, which is the most liquid of the above investments, is the riskiest. After all, you know your cash will lose value because of inflation. And, someone could steal your bed, whereas the FDIC insures your bank deposits.

Nonetheless, it is also easily understood that an investment in the stock market is both less liquid and more risky than keeping your money in the bank.

Now, compare an investment in a publicly traded stock with an investment in a private company, whether it is a direct investment, or an investment through a VC fund or a PE fund.

The public company investment is generally understood to be a more liquid asset (though, as online platforms and portals become more pervasive, this may change), because the investor can generally sell public company stock online with the push of a button or a call to her broker.  But is the public company investment less risky than the private company investment?

This is a complicated question, the answer to which is no. The riskiness of an investment in a private company is no more or less risky than one in a public company solely by virtue of the fact that it is private; the assessment of a company’s riskiness must be made on a company-by-company basis, and it is our opinion that whether the company is private or public, by itself, should not factor into the analysis.

The Mainstreaming of Alternative Assets

Advising investors to have a properly diversified investment portfolio is standard advice. But what is proper diversification? For quite a long time, many investment professionals have viewed this to mean that an investor should have a mix of cash, publicly traded stocks, bonds and perhaps real estate, with further diversification within each asset class. For example, the general wisdom is that liquid assets like publicly traded stocks should be divided between companies that are small and large; domestic and foreign; and in varied industries.

We believe that within a few short years, most investment advisors will be recommending that investors with the means should also diversify into these more illiquid assets. As Henry Yoshida, CFP tells Forbes:

“Savvy institutional investors and high net worth individuals are shifting their exposure away from stocks and into alternatives such as real estate, private equity and cryptocurrencies to tap into new and diversified investment strategies. Alternatives offer both institutional and retail investors the potential for higher returns and also provide exposure to assets that are uncorrelated to public markets, which can shelter your portfolio during times of market volatility.”

There will be a little bit of a self-fulfilling prophecy effect; as more and more money moves into alternatives, prices should be buoyed. We think the effect will have permanence, however, as more and more people come into the market for alternatives.

Don’t Run Before You Walk

The most famous actors, athletes and singers make millions of dollars a year. But most actors, athletes and singers never make it to that level.

Another book about investing in alternative assets, The Alternative Manifesto, starts chapter one with these two sentences:

Yale’s endowment is up 100% over the past, extraordinarily difficult, decade? I won’t ask how you did.

So, what’s up? Using all that IQ to pick great stocks? Hardly. The trick, in fact, is that mostly they aren’t picking stocks at all: in 2012, only 6% of Yale’s portfolio was in U.S. equities. Instead, fully half resided in things called “absolute return,” “private equity,” and “real assets” strategies. Another big chunk was in emerging markets. Those are the secret ingredients of an investing formula that is now widely followed by most other endowments, foundations, and the rest of the smartest money on the planet.

We take issue with this. First, the fact that Yale University was able to achieve this result tells us nothing about what the average accredited investor has done, or will do, with an alternative, asset-heavy portfolio. We think that sensationalizing and trying to appeal to the psychological tendency of many people to think they will do better than average is, in a word, irresponsible. Further, while the way Yale University invests its nearly $20 billion endowment is interesting, how much relevance does it have to the average accredited investor? We submit, not much.

We do not “tout” alternative assets as being appropriate for all accredited investors, and we certainly do not recommend that you run to make such investments. We do think, however, after appropriate investigation and analysis, you are quite likely to conclude that some exposure to alternative assets will make sense for you—but not because you are going to duplicate Yale’s success.

Where to Learn More About Illiquid Assets

We have not attempted to make this series all things to all investors. Rather, we intend this to introduce you to the world of illiquid assets.

Our favorite primers on investing, while ostensibly aimed at stock market investing, have broader applicability. We’d recommend these books to anyone who has not read them:

• A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (Twelfth Edition) by Burton G. Malkiel.
• Understanding Wall Street (Fifth Edition) by Jeffrey Little.
• All About Value Investing by Esme Faerber.

If you are looking for a more comprehensive book about financial planning in general, we recommend:

• Private Wealth Management: The Complete Reference for the Personal Financial Planner by G. Victor Hallman and Jerry Rosenbloom.

If you want to take a deeper dive into the currents of private equity and venture capital, these are the best books we know of:

• Introduction to Private Equity: Venture, Growth, LBO and Turn-Around Capital by Cyril Dema.
• Mastering the VC Game: A Venture Capital Insider Reveals How to Get from Start-up to IPO on Your Terms by Jeffrey Bussgang.
• The Masters of Private Equity and Venture Capital by Robert Finkel and David Greising.
• Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist by Brad Feld. Jason Mendelson. and Dick Costolo.

For more on hedge funds, the book we like best is:

• All About Hedge Funds (Second Edition) by Ezra Zask.

Of course, among internet-based resources, we recommend (with some admitted bias) Financial Poise. We recently published the first installment of our own beginning investing series.

Another resource to visit is the Financial Industry Regulatory Authority, Inc. (FINRA) site, which is a private corporation that acts as a self-regulatory organization. It is the successor to the National Association of Securities Dealers, Inc. (NASD) and the member regulation, enforcement and arbitration operations of the New York Stock Exchange. Among other things, FINRA writes and enforces rules governing the activities of more than 4,135 securities firms and approximately 632,050 brokers.

One of the many resources offered on FINRA’s website is its BrokerCheck®, which allows anyone to check the background of an investment professional or firm. You can find out, among other things, whether a broker or investment adviser representative is licensed in a particular state to conduct business, and whether she has been sanctioned by securities regulators for violations of investment-related regulation(s) or statute(s).

Don’t Get Defrauded

Yeah, we know. You want to thank us for this insightful and non-obvious tip.

All joking aside, it is easier than you think to fall for a financial scam. Just see Wolf of Wall Street, or think about a guy named Bernie Madoff. Or for that matter: Martin Frankel, Dennis Kozlowski, Ken Lay, James Lewis, Barry Minkow, Lou Pearlman, Charles Ponzi and John Rigas. Search any of their names and the word “fraud,” and you will see the breadth and scope of what creative people can do.

Because alternative assets represent an interesting opportunity, which nearly any accredited investor should consider, fraudsters are already taking aim. Even in the absence of outright fraud, keep in mind that many seemingly objective sources of information are not always so objective.

You should not let this deter you from the asset class, just as you should not stop investing in NASDAQ stocks and other liquid assets just because there are dishonest stockbrokers in the world. But be vigilant.

Do your due diligence, and make sure you are getting your information from objective and accurate sources. Get references on people you are considering trusting your money with, and check those references. Lastly, alternative assets are not some sort of panacea; if something sounds too good to be true, it probably is.

One Last Word About Diversification

We use the word “diversification” more than a dozen times in this series, each time in a positive way. Interestingly, John C. Bogle, founder of Vanguard, believes that alternative assets don’t do the job they are intended to; that they fail to provide diversification in major downturns when investors need it most. See Niall J. Gannon, Investing Strategies for the High Net Worth Investor (2010) at 38.

Bogle is just one guy, and he could be wrong. Regardless, there is a certain logic to the thinking: if most people lose a lot of money in the stock market, it stands to reason they may have less to spend on certain types of illiquid assets, like collectibles. On the other hand, regardless of how bad the market is, people need to eat. On that note, I think I’m going to go buy a farm.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: What is a “Private Fund?” and Due Diligence Before Investing.]

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