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The JOBS Act and the Accredited Investor: "About Bob"

Are you an accredited investor who doesn’t know much about accredited investing?

Did you recently hear something about the JOBS Act, have a vague idea that you want to learn more, but are not sure why?

Are you well diversified in stocks, bonds, mutual funds, and maybe some precious metals, but you have no exposure to private equity of venture capital?

Interested in being an angel investor but not sure how to do that?

Accredited Investor Markets Presents “Accredited Investors and the JOBS Act: About Bob”

By: Vanessa Schoenthaler and Jonathan Friedland

One in a series of articles explaining why and how, following the 2012 JOBS Act, Accredited Investors will likely change their investment strategies

Are you an Accredited Investor and, if so, what does that mean?

Let us introduce you to Bob.

Bob lives in Middle America, where he owns a nice house in a middle class neighborhood and drives a practical car, which he bought, used several years ago.

Bob isn’t fancy, however. In fact, if you asked him, Bob would tell you that he was just an ordinary guy. JOBS Act and Accredited Investors

Meet Michele. Michele lives in a large coastal city. She owns a nice, but not over-the-top condo in a residential neighborhood and walks or relies on public transportation to get to work. Michele isn’t fancy either; she’s just an ordinary urbanite.

Finally, meet David and Isabella. They live, with their two school-age children, just outside of a mid-sized city. They also own a nice house in a nice suburban neighborhood and each drives a nice, but not new car.

But like Bob and Michelle, David and Isabella aren’t fancy and if you asked them they would also tell you that they’re just an ordinary family.

Aside from being ordinary, there is one other thing that Bob, Michelle and David and Isabella all have in common: they’re all accredited investors.

Who is an accredited investor?

A down and dirty definition of an accredited investor is someone whose net worth, either alone with a spouse, exceeds $1 million (not including the equity in her or his primary residence) or someone who has earned more than $200,000 (or $300,000 with a spouse) for the past two years and reasonably expects to earn more than $200,000 (or $300,000 with a spouse) in the current year.

What’s the significance of being an accredited investor? In a nutshell, accredited investors are able to participate in certain alternative investment opportunities that are not otherwise available to non-accredited investors. Think: private equity, venture capital and angel investments, hedge funds, private shares, [NTD: private shares are not really a thing … shares in a pre-IPO company acquired in a direct/angel/VC investment made through a private placement] and private placements.

Being an accredited investor without investing like one

Getting back to our accredited investors…

Bob is self-employed. He owns a factory that employs about 50 people. It’s located in the same town that he lives and grew up in. Bob’s net worth is about $35 million, making him an accredited investor under the net worth standard.

Michele is a doctor. She works in busy emergency room located on the opposite coast from where she grew up and went to medical school. With several years of experience under her belt, Michele’s salary is comfortably in excess of $200,000 a year, making her an accredited investor under the individual income standard.

David is a Senior IT Specialist at a Fortune 500 company and his wife, Isabella, is a Marketing Director at a midsized private company. They met in college, married, and not too long thereafter started a family. Over the last several years, their combined salaries and year-end bonuses have exceeded $300,000 a year, making them accredited investors under the joint income standard.

Each of Bob, Michele and David and Isabella are accredited investors, yet none of them has ever participated in an alternative investment opportunity requiring that they be an accredited investor. Most of their investment funds are held in IRAs, 401ks or 403bs, in publicly traded mutual funds, individual stocks, and bonds, and, in Bob’s case, in his own business and some local real estate.

So why haven’t any of these accredited investors participated in an alternative investment opportunity?

Let’s take a closer look at Bob. Bob doesn’t live in Greenwich, Connecticut, Silicon Valley, or any of the other affluent suburbs of major metropolitan cities where he’s likely to have investment bankers, tech entrepreneurs, or fund managers as friends and neighbors. Nor does Bob have a finance degree or an MBA. He is completely uninitiated when it comes to the world of alternative investment opportunities and accredited investing.

What’s more, until recently the federal securities laws prohibited accredited investment opportunities from coming to Bob unless they came through someone that Bob already had a relationship with. In other words, the law prohibited anyone from conducting a “general solicitation” or any sort of public advertising to attract accredited investors. As a result, without knowing the right kind of people, Bob has historically been out of luck in terms of being exposed to alternative investment opportunities.

However, as a result of the Jumpstart Our Business Startups Act (or “JOBS Act” for short), on September 23, 2013 everything changed. Under the JOBS Act, entrepreneurs, companies, private equity and venture capital fundshedge funds and others are now able to advertise investment opportunities and solicit investments from accredited investors, including Bob, Michele, and David and Isabella.

While there are many important features of the JOBS Act, its lifting of the prohibition on general solicitation and adverting is the key-most feature for people like Bob, Michele, and David and Isabella.

Accredited investors will be bombarded with sales calls

Now that the necessary JOBS Act regulations are in place, accredited investors like Bob, Michele and David and Isabella are going to be bombarded by broker-dealers and other investment intermediaries, private equity and venture capital funds, entrepreneurs, and others, all seeking to persuade them to allocate a portion of their investment portfolio to alternative investment opportunities.

Accredited investors who are not experienced in making such investments will suffer some degree of information overload, as they get up to speed on these investment categories. There will also be scams and schemes designed to take advantage of their lack of knowledge. At the same time, however, the opportunity to diversify into these alternative investments offers accredited investors the potential for greater overall investment returns and smart diversification.

Changes in the law as a result of the JOBS Act will not be well covered outside of niche media because an overwhelming majority of the upward of 10 million accredited investors (estimates vary) in the U.S. have never made an investment that requires them to be one. Why? Because they are like Bob, Michelle and David and Isabella.

If you are in the same boat, you will want to understand this area—even if only to decide it is not for you.

Why this Series?

Our purpose is to introduce you to the private markets for alternative investment opportunities that are available to accredited investments, to educate you about how they operate, and to inform you of the many changes that are taking place.

We are not here to try to introduce you to the next big investment opportunity or to try to convince you that alternative investments are the right kind investments for you. Our basic mission is to provide you with objective and reliable information that you can use to decide for yourself.

What Kind of Alternative Investment Opportunities Are Available to Accredited Investors?

The very point of being an accredited investor is that there is a whole world of alternative investment opportunities available to you that are not available to non-accredited investors.  And, if you are an accredited investor, it would be irrational for you to not at least consider including some of those alternative investments in a well-balanced, diversified investment portfolio.  However, before you can properly consider where, if at all, alternative investments fit into your portfolio, you must first understand what the world of alternative investments looks like and where to access such opportunities.

Defining Alternative Investment Opportunities

There are many different ways of categorizing the alternative investment opportunities available to accredited investors; no one universally accepted approach exists. That said, for our purposes, we group alternative investment opportunities into the following four overarching categories:

  • private equity;
  • venture capital;
  • hedge funds; and
  • hard assets

Private Equity

Strictly speaking, the term “private equity” can apply to any investment into the ownership of a private company. Accordingly, private equity, in its broadest sense, encompasses everything from angel investments to venture capital to leveraged buyouts.
The more common meaning, and the one we subscribe to, is this: private equity refers to an actively managed pooled investment in the equity (or equity-linked securities) of an established private company. In particular, either a in an established private company.

Often, but not always, such investments are “control” investments. A control investment is exactly what it sounds like: one through which an investor gains control of a company, typically by acquiring a majority ownership interest in it (and control of its board of directors).

An established private company is one that has a financial track record (generally, but not always, including positive EBITDA), a quality management team, an addressable market, and strong future growth prospects.

Most private equity investments are conducted by “private equity funds.”  A private equity fund is like a mutual fund except that (a) instead of accepting investment funds from just about anyone, private equity funds only accept investment funds from accredited investors; and (b) instead of pooling the money from their investors to buy large stakes of publicly traded companies, private equity funds invest in (or buy outright) privately held companies.  Another common- perhaps universal- practice of private equity firms is that they always employ leverage when they make investments.  In other words, some significant portion of what a private equity funds pays for any given acquisition is paid with money that is borrowed.  Indeed, another name for a private equity firm is “leveraged buyout’ firm.

Venture Capital

Like private equity, the term venture capital also refers to an actively managed pooled investment in the equity or equity-linked securities of a private company. However, unlike private equity, venture capital investments are generally minority investments in start-up or growth companies.

A minority investment is one through which an investor acquires a minority ownership interest in a company. In the context of venture capital, a minority investment generally takes the form of preferred stock with additional control rights and appropriate downside protections.

There is no universally accepted definition of a start-up company. For our purposes, we use the term to mean a company that has passed the concept stage but has a limited operating history. A start-up company is operational but in the early stages of development; it may have a completed prototype, initiated production, developed customer relationships or even secured initial sales.

Again, there is no universally accepted definition of a growth company, however, few use the term to mean a company that has transitioned from the early stages of development to one with more formal organizational and management structures. A growth company has established a proven business model and is on its way to becoming or already is sustainably profitable.

Anatomy of a Private Equity and Venture Capital Fund

Private equity and venture capital investments are made through close-ended funds. Close-ended funds, in essence, are professionally managed pools of money that are invested over a finite period of time (in the case of private equity and venture capital funds, typically ten to twelve years, with an option to extend that term for up to three consecutive one-year periods).

In the traditional fund model (the “committed” or “blind pool” model) a management team or “sponsor” will organize a fund and serve as its general partner. The sponsor will then raise binding capital commitments from a group of passive investors (who will make up the fund’s limited partners) in a private placement of the fund’s ownership interests. Typical fund investors might include public and private employee benefit plans, university endowments, insurance companies, banks, sovereign wealth funds, family offices and individual accredited investors.

From an investor’s prospective, a fund’s life cycle can be broken down into three somewhat overlapping periods: the investment period, the holding period, and the divestment period.

During the investment period, once a fund secures capital commitments, it will begin to source and evaluate investment opportunities with the assistance of an investment management firm or investment advisor (who may be an affiliate of the fund’s sponsor). As the fund executes investments, the sponsor calls on investors to contribute capital in accordance with the terms of their binding capital commitments. The investment period typically spans the first three to five years of a funds life.

anatomy of a private equity and venture capital fund

Following the investment period, and during the holding period, a fund will maintain the investments in its portfolio for a period of five to seven years while they develop and appreciate in value. A fund will also sometimes make “follow-on” investments during the holding period. A follow-on investment is an additional investment into an existing portfolio investment. Lastly, during the divestment period, a fund will liquidate its portfolio of investments and distribute proceeds to its investors.

The traditional model is only one example of how you can structure a private equity or venture capital fund. A variation on the traditional model, one that has recently gained popularity, is the “pledge” or “fund-less sponsor” model.

Structurally a pledge fund can be very similar to the traditional fund model. The key difference, however, is that in the pledge fund model investors’ capital commitments are non-binding. So, after the sponsor identifies an investment opportunity, it must go back to the pledge fund’s investor base and raise capital specifically for that opportunity. Thus, rather than having a readily available pool of investment capital to draw from, as in the case of a traditional fund, a pledge fund sponsor must raise capital on a deal-by-deal basis.

As an aside, it is possible, though rare, for an individual accredited investor to invest directly into a growth stage or established private company, rather than investing through a fund. In such a scenario, what typically happens is that the private company will conduct a private placement of securities (as described below) and the individual investor will participate in the offering alongside other accredited investors (typically institutions, funds or both). Such an investment, where several unrelated investors come together to participate in one transaction, is referred to as a “syndicated investment” or “club deal.”

Where Does Angel Investing Fit In?

Angel investing can really be thought of as a subcategory of venture capital investing. Angel investors are individual accredited investors that invest their own funds directly, as opposed to through a venture capital fund, into nascent seed and early start-up stage companies. Oftentimes, angel investors are themselves former successful entrepreneurs and in addition to monetary support they provide nascent companies with both mentoring and networking opportunities.

A seed stage company is one that is just getting off the ground with a concept, product or service; it may not yet be operational and usually only raises small amounts of money (generally between $50,000 and $1 million).

Much of the hoopla you have been reading about regarding equity crowdfunding is about angel and seed opportunities. The JOBS Act of 2012, among other things, permits (a) non-accredited investors to invest in such companies, to a limited extent; and (b) such companies to broadly advertise the opportunity to invest in them. It is these two changes to the securities laws that are the reason why equity crowdfunding is such a hot topic these days.

A Word About Private Placements

In addition to angel investments, individual accredited investors also participate directly in all manner of private placements. A private placement is a private sale of securities to an individual or group of accredited investors. Securities sold in a private placement can be in any form, including equity, equity-linked and debt, and can be issued by any type of entity, including funds, private companies and even public companies (usually in private equity-like transactions called PIPEs, an acronym for a private investment in public equity). This is to say, private placements are not reserved solely for use by private equity or venture capital investors. Rather, a private placement is a means through which any entity can raise private capital from a group of investors.

Hedge Funds

Hedge funds, like venture capital and private equity funds, are actively managed, pooled investment vehicles that invest the funds of several types of investors, including individual accredited investors. Unlike venture capital and private equity funds, hedge funds invest in a range of assets classes, including public and private securities and derivative instruments, with most hedge funds typically focusing on assets that are free from restrictions on transfer and which have fairly liquid trading markets.

Structurally, hedge funds differ from private equity and venture capital funds in a number of important ways. For starters, hedge funds are open-ended funds. Meaning that, subject to any limitations set forth in their organizational documents, hedge funds can accept new investors and redeem the interests of existing investors at any time. What’s more, open-ended funds are not typically subject to a specific term, so once formed a hedge fund exist indefinitely. Another important structural difference is in the way investors contribute funds. A hedge fund investor makes their entire capital contribution when they are admitted to the fund, rather than committing or pledging to contribute capital in the future as in a private equity or venture capital fund.

Hard Assets

In addition to private equity funds, there are a number of private equity-styled investment vehicles that pool and invest the funds of several types of investors, including individual accredited investors, into alternative assets. Examples include fine art funds (e.g., The Fine Art Fund Group), rare coin funds (e.g., CAMI’s coin funds), wine funds (e.g., The Wine Trust fund), commodity pool funds and non-traded real-estate investment trusts.

The Lifting of the Ban

If you are not a lawyer, fund manager, CEO, or entrepreneur, you may have never heard of the JOBS Act.  However, if you are an accredited investor, you will increasingly be exposed to the JOBS Act over the coming months, even though you may not realize it at first.

Let us explain.

In essence, the JOBS Act was designed to do two things:

  • open up the public capital markets to those smaller companies wanting to go public by easing certain of the regulatory requirements associated with being a public company; and
  • enlarge the private capital markets by making it easier for entrepreneurs, companies, private equity funds, venture capital funds, hedge funds and any other issuer of securities (all of whom we’ll refer to as “issuers”) to reach out to potential investors, raise capital and, in the case of private companies, to choose to remain private for a longer period of time or even indefinitely.

In many ways, the JOBS Act is a remarkable piece of legislation. From introduction through enactment, it took less than four months for to pass through both the House and Senate (quite a feat in and of itself), and it was signed into law by President Obama on April 5, 2012.

Even more notable, weighing in at a mere 22 pages, the JOBS Act embodies some of the most significant changes to private capital formation since the federal securities laws themselves were first enacted in 1933.

Its adoption was not without controversy, however, having been characterized as everything from a welcome attempt at uncuffing capitalism to the equivalent of a “Bring Fraud Back to Wall Street Act”.

But, again, you probably haven’t heard all that much about the JOBS Act, other than perhaps that it has something to do with crowdfunding (more on this here).  That’s because the JOBS Act wasn’t self-executing.  In other words, even though the JOBS Act was signed into law in April 2012, the Securities and Exchange Commission (“SEC”), the agency primarily responsible for enforcing the federal securities laws, still had to adopt rules and regulations to put into play many of the provisions related to the private capital markets; the provisions that most directly affect you as an accredited investor. Now, with some of the SEC’s rulemaking initiatives recently completed and others underway or on the horizon, you may finally start to hear more about the JOBS Act.

Lifting Alternative Asset Bans - The JOBS Act and Accredited Investors

A word about the federal securities laws and private capital formation

Before it’s possible to really appreciate the changes that the JOBS Act has and will continue to bring to the private capital markets and to alternative investment opportunities, it’s important to consider how private capital formation functioned in the context of the pre-JOBS Act securities laws.

By way of background, the U.S. stock market’s infamous 1929 crash marked the end of an eight-year bull run that was fueled by excessive leverage, insider manipulation and widespread speculation.  Three years later, when the market finally bottomed, the Dow Jones Industrial Average had lost a staggering 89% of its value.  In that same year, at the height of the Great Depression, the U.S. Senate Banking Committee launched an investigation into the causes of the 1929 crash and how to prevent similar crashes from occurring in the future.  The Committee’s findings ultimately led Congress to enact the first U.S. federal securities law: the Securities Act of 1933 (the “Securities Act”).

In essence, the Securities Act requires that all offers and sales of securities be registered with the SEC or that they be exempt from registration pursuant to one of the enumerated exemptions available under the Securities Act.

By far the most commonly utilized exemption from Securities Act registration is the private offering exemption afforded by the safe harbor of Rule 506 of Regulation D, promulgated under Section 4(a)(2) of the Securities Act.

Historically, Rule 506 allowed issuers to raise an unlimited amount of capital from an unlimited number of accredited investors and up to 35 sophisticated non-accredited investors (provided that, when sophisticated non-accredited investors participate in an offering, certain information disclosure requirements are met).

However, as Rule 506 is a private offering exemption, issuers were prohibited from engaging in any type of general solicitation or general advertising.  As a result, an issuer raising capital in a private offering under Rule 506 could only solicit investments from potential investors with which the issuer (or an intermediary acting on the issuer’s behalf, such as, a placement agent or investment bank) had a pre-existing, substantive relationship.  This effectively limited the pool of potential investors to those already within an issuer’s existing network and, likewise, limited your opportunity to participate in alternative investments to those private offerings being conducted by issuers, or through institutions, with which you already had a pre-existing, substantive relationship.

JOBS Act changes to private offerings

Under the JOBS Act, the SEC was required to eliminate the prohibition on general solicitation and general advertising for private offerings made in reliance on a new subsection of Rule 506 where all of the purchasers of an issuer’s securities are accredited investors.  The SEC has enacted rules and amendments to implement this change, and those rules and amendments took effect on September 23, 2013.

You may not realize it just yet, but you’re standing at the threshold of a whole new world of alternative investments. Now that amended Rule 506 is in effect, and as other provisions of the JOBS Act are implemented over time, you will be increasingly exposed to an array alternative investment opportunities which you might not have otherwise had access to and in forms that may not have ever existed before.

Crowdfunding, Kickstarter, and the Accredited Investor 

Let’s stop for a moment and consider crowdfunding, which you probably have heard of, and Kickstarter, one of the most well-known types of crowdfunding platforms and one of the least important to you as an accredited investor.

All the noise about crowdfunding

It’s not that Kickstarter doesn’t matter at all.  Kickstarter has in fact been a pioneer in the nascent market for crowdfunding and the platform that it provides has been instrumental in the funding of tens of thousands of creative ventures.

Nevertheless, while Kickstarter may provide a platform that allows for the pooling of resources to fund a venture—the essence of crowdfunding—it’s not a platform for making investments, at least not in the traditional sense of the term.  That is to say, you cannot not earn a financial return by backing a project on Kickstarter.  Your return on investment comes in the form of knowing that you have helped to bring a project to life and, oftentimes, in the form of swag.  Swag are perks of varying degree, for example, if you were to make a certain minimum contribution to a movie project you might get a DVD copy of the finished film, whereas a larger contribution might get you a production credit or an invite to the premier.

To date, the most successful project to receive backing on Kickstarter is Pebble, a customizable watch that connects with a user’s smartphone to run apps. Pebble set out to raise only $100,000 on Kickstarter, but ended up raising $10,266,845 from 68,929 backers.

Another example of an extremely successful Kickstarter project is Ouya, an open video game console.  Ouya set out to raise $950,000 on Kickstarter, but ended up raising $8,596,474 from 63,416 backers.  Ouya is the eighth Kickstarter project to raise more than one million dollars.

Even more examples of Kickstarter success stories include Amanda Palmer’s project to raise funds for the manufacture and distribution of an independent album (a $100,000 goal, with $1,192,793 raised),  Rich Burlew’s project to raise funds for the reprint of the out-of-print comic The Order of the Stick (a $57,750 goal, with $1,254,120 raised) and Ministry of Supply’s project to raise funds for the manufacture and distribution of a high-tech, fashionable dress shirt (a $30,000 goal, with $429,276 raised).

It’s success stories like these that naturally led to a Time Magazine article: The Kickstarter Economy (subscription required), which poses the question:

“Could Kickstarter and its crowdfunding competitors and imitators end up competing with venture capitalists and angel investors and other sources of funding for startups of all sorts?”

With respect to Kickstarter, at least in its present form, the answer is no.

To begin with, there are several restrictions on the types of projects that can raise funds through Kickstarter.  Its Project Guidelines require that all projects fall within one of a limited number of categories covering things like art, music, technology and theater.  With the exception of technology, there aren’t many angel investors or venture capital firms that focus on the same kinds of categories as Kickstarter does.

Kickstarter’s Project Guidelines also require that projects have a clear goal that can eventually be completed. Therefore, you can’t use Kickstarter to raise funds to start a business or for general working capital to fund ongoing operations; you have to have a specific, attainable purpose in mind.

What’s more, the average Kickstarter project is modest, even minuscule, in comparison to outliers like Pebble, Ouya, and even Ministry of Supply.  In the Time Magazine article, Kickstarter co-founder Yancey Strickler, tells us that a typical project only raises about $5,000 and is supported by 85 backers.  Compare that to the typical angel investment round of about $341,800.

Thus, the kinds of businesses that raise funds from angel investors and through venture capitalists and the kinds of individuals and businesses that launch projects to raise funds through Kickstarter are likely to be very different.  That’s not say that a Kickstarter project can’t form the basis of an angel or venture-backed company, it’s just not likely that the two will be competing for the same investment deals any time soon.

So you see, Kickstarter actually occupies a valuable niche in the crowdfunding marketplace, it’s just that Kickstarter and similar platforms don’t really matter to you, as an accredited investor.

So … what is crowdfunding?

This might naturally lead you to ask, if platforms like Kickstarter’s are not relevant to accredited investing, should accredited investors be concerned with crowdfunding platforms at all?  Possibly, remember the Kickstarter platform is an example of only one type of crowdfunding platform.

More generally, the Oxford dictionary defines crowdfunding (sometimes also called crowd-sourced funding, crowd financing or social funding) as “the practice of funding a project or venture by raising many small amounts of money from a large number of people, typically via the Internet.”

When considered in this broader context, any number of a variety of platforms can come within the definition of crowdfunding.  Even so, we can generally categorize existing crowdfunding platforms into one of four business models:

  • Donation Model – The donation model of crowdfunding is exactly as it sounds; participants donate funds to support a cause without any expectation of a return on investment.  Examples include GoFundMe and Rally, which allow anyone to raise funds for anything from a personal project to a political campaign, and everything in between.
  • Reward Model – In the reward crowdfunding model, participants contribute funds to support a cause and receive a reward in return for their contribution.  Rewards never take the form of an economic or other participatory interest in the business or cause.  Examples of crowdfunding platforms that use the reward model include Kickstarter, as well as IndieGoGo and Fundable.
  • Peer-to-Peer Lending Model – In the peer-to-peer crowdfunding lending model, participants lend funds to support a cause with the expectation of those funds being repaid, sometimes with interest and sometimes without.  Examples of crowdfunding platforms that use the peer-to-peer lending model include Kiva, LendingClub, and Prosper.
  • Equity Model – The equity model most resembles a traditional investment model by which participants contribute funds and in return receive an ownership interest in the business.  As a consequence of current federal and state securities laws, the equity model is primarily available only to accredited investors.  However, once the SEC implements the crowdfunding provisions of the JOBS Act, the equity model will also be available, in a limited form, to non-accredited investors. Examples of crowdfunding platforms that use the equity model include CircleUp, and MicroVentures.

Accordingly, it is the equity model of crowdfunding that an accredited investor should be most concerned with.  A word of caution however: it is important to recognize that while crowdfunding platforms may appear to you to be operating under and regulated by the JOBS Act, they in fact are not.  Equity crowdfunding platforms in particular rely on pre-JOBS Act federal and state regulations and SEC interpretations.  What’s more, many have only been in operation for a few years, at most, and new platforms seem to be popping up all the time.  As such, you should be just as diligent in your selection of a crowdfunding platform as you would be in your investment selection.

the jobs actPrior installments in this series explain that one of the reasons alternatives assets will be more and more relevant to you is because they help with diversifying your portfolio. Why? And isn’t that what bonds are for?

Bonds historically helped protect the overall portfolio when stocks went down

Because most investors are somewhat risk adverse and capital preservationist in nature (rather than speculative, high risk investors), financial advisors generally tended to place a significant amount of investable assets in bond and bond-related assets, with a small portion in cash. This was done because investment professionals know that, while most investors would love to see constant, predictable, steady growth in the stock markets over weeks, months, and years, the reality is that stock markets can be (and often are) quite volatile and erratic.

The concept was simple: the equity portion of a portfolio would provide growth over market cycle; the bond portion of the portfolio would provide “downside protection;” and the cash would provide the “dry powder” for any future investing opportunity that might occur.

Why bonds?

Why bonds? Because while bonds have historically returned on average 2%-3% per year (much lower than the average return of many stock portfolios), there have been times in the past when bonds have returned 4% or more at the same time stocks have fallen 10% or more. With the proper diversification between the two basic asset classes, higher returns could be achieved with lower volatility (downside risk) over time.

This theory was proven by Harry Markowitz’s 1952 publication Portfolio Selection: Efficient Diversification of Investments. Markowitz showed that risk could be adjusted with the addition of bonds, and that risk could be ratcheted up and down with the inclusion or subtraction of bonds in an all equities portfolio. This became known as “Modern Portfolio Theory.”

wall street bullSo, because it was measured that when the stock markets move downward, bonds most likely gain in price. In other words, the combination of stocks and bonds have a see-saw effect with the stock/bonds moving against each other, overall creeping up in price in all market conditions. The system was simple and it worked:  a stock/bond portfolio, each moving up in price when the other moved down.

The three-piece pie chart

To be clear, today (and in the past) most accredited investors have (and had) a three asset class portfolio: stocks, bonds, and cash.  While the specific vehicle might be mutual funds, ETFs, and/or individual stocks and bonds, there still was some combination of only these three basic assets classes.

But times are a changing…

Today, the situation is different. Bonds are more volatile and unpredictable than ever before due to the current low interest rate environment. So, what’s an investor to do?


Friedland is founder and chairman of DailyDAC, LLC, which owns and operates Valentine is a contributing writer for AIMkts.

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