How Much in Private Investments is Appropriate?
Daily discussions with investors, who initially discover the world of private investing, focus on two main topics: Qualification and Suitability. Qualification deals with having the necessary income or asset minimums to then begin the suitability discussion. Today’s article will deal with the principles of investor suitability, main points for an investor to consider, and how this applies to you.
A well-designed portfolio, with an appropriate allocation to private investment products and other alternatives, can actually lower your overall portfolio risk. However it is extremely important to get it right the first time.
How Much Risk is Appropriate?
When considering the myriad of financial instruments and products available to Canadians (including stocks, bonds, GICs, insurance products, and private investments, to name a few), many investors seem to seek out returns without gauging how much risk they are taking. In fact every investment you purchase contains an element of risk. Even GICs and AAA-rated bonds, while providing government-guaranteed protection, subject an investor to the potential loss of purchasing power over time. So it makes sense to understand:
- The way in which various investment fit together, to form a portfolio, and can maximize return while reducing risk
- The actual risk inherent in every financial instrument you purchase
- Appreciation of the risk inherent in concentrating too much capital into any single asset class or individual security
- Understanding your actual risk tolerance versus how much you may think is appropriate
For most investors, allocating too large a portion of a portfolio towards illiquid, private investments would generally be considered inappropriate, due in no small part to liquidity constraints presented. For example, let’s say you discover the wonderful world of private products for the first time, and start to invest. You start receiving monthly and quarterly cashflow at 8-10% annualized rates. Who wouldn’t love this? So you adopt the attitude that “if a little is good, a lot must be great!”, and decide to invest larger and larger sums into private offerings (or worse yet the same offering). Before you know it most of your money is tied up in illiquid investments. Then the unexpected happens, such as a health scare, requiring you to take time off work which reduces income. You now need to sell some of your private holdings, but cannot, because there is no secondary market for these products. Maintaining a healthy allocation to cash and other liquid investments would have saved you.
In addition, owning more than 10% of your net financial assets in a single private offering generally becomes a concern of concentration, due to the fact that anything can happen to any single product. Instead of placing $100K into a single product, for example, placing $20K into a diversified mix of 5 quality products significantly reduces concentration risk.
Another question you should ask yourself, or discuss with your advisor, is “How much of my financial assets, as a percentage, could I completely lose, without the loss drastically affecting my current standard of living, future retirement plans, or peace of mind?” For some, the answer is zero, which means you should almost never purchase private exempt market products. Some may be able to withstand a 20-40% loss with no concerns. And yet others, such as a young doctor, with high income, no real financial responsibilities such as a family or mortgage, and many years to recover, can potentially tolerate a much higher allocation. The test should encompass all aspects of an investor’s situation and be customized. The test should also be based on an individual and not subject to all-encompassing rules.
Perceived Vs Real Risk Tolerance
There is nothing wrong with taking on intelligent investment risks. In fact, if you ever desire superior returns, risk must be taken. Otherwise, it would be best to buy your average balanced mutual or index fund, and generate average returns. However, in my opinion, too many investors do not possess an accurate gauge of their true risk tolerance. This could be due to a number of factors:
- Less than 5 yrs experience investing
- Have never experienced a loss
- Do not understand the actual risks inherent in an individual security or asset class
- A short, perhaps 3 -5 yrs, period of investment success (makes one feel invincible)
- Not considering the consequences of a total loss
Getting a handle on your real tolerance for risk will go a long way towards creating an investment portfolio that truly meets your needs.
All Things Being Equal, More Money is Better
The fact remains that, all things being equal, the higher your asset totals the more freedom you have regarding private capital investing. For example, if your net worth is 500K, and total net investment portfolio 200K, and you want to place 50% in private illiquid products, a total loss would most likely affect your standard of living tremendously. On the other hand, for an individual with a 5MM net worth and 2MM portfolio, that same 50% portfolio loss would affect them but not be devastating to their base standard of living. They would still most likely be able to enjoy a relatively comfortable lifestyle. This is one of the principles being why the qualification rules for accredited investors make sense. Many believe that an investor should be able to buy whatever they want, without “the government telling me what I can and can’t do”, and fiercely defend the freedom to do so. Conversely, all investors should be aware of the true risks, and potential consequences.
I would encourage everyone to consider the implications of any investment path they wish to take. For most, this requires consultation with an experienced advisor who can assist with these considerations, ask the right questions, and provide recommendations that reflect the complete picture. More time should be spent on this process than simply examining individual products. Additionally, a great deal of time should be spent assessing the expertise of the advisor, to afford the greatest opportunity for investment success.
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