Am I missing out if I’m not investing in privates?
Ask A Financial Advisor
Should I be investing in private investments? There’s so many startups now that can help you invest in venture capital funds, private equity funds, angel investing, private credit, private real estate deals and more. My spouse and I are already maxing out 401(k) – is this the next step?
Signed, “Is My Portfolio Basic?”
Dear Basic:
Growing up in the church, I’d hear tales of “Africa.” “In Africa, this is what it’s like for Christians,” “We sponsor a family of missionaries in Africa,” “People in Africa really love my jokes.” (That was Pastor Phil.)
But of course, “Africa” is a very large and diverse continent: the geography alone encompasses the Sahara desert, the jungles of Rwanda, the marine life of Mozambique, the mountains of Cape Town and more – much less the diversity of history, nationality, identity and culture.
Similarly, “privates” is a sweepingly large category, encompassing everything from small direct investments (renting out a condo, investing in your buddy’s startup) to massive pooled vehicles (private equity buy-out funds, debt funds, etc..) Where investing goals and resources can be so unique, and where the characteristics of any individual investment can be so heterogenous, generalizations are difficult.
That said, where you can make generalizations, public markets come out looking pretty good next to private investing:
Lower fees: You can buy Vanguard’s Total Stock Market Index Fund for 0.04% per year in fees. A common fee model for private funds is “two-and-twenty”: 2.0% per year, plus 20% of profit. Privates must outperform public indices by a large margin to make up for these higher fees.
Greater liquidity: Think about the equity in your house: even if Zillow shows you’ve “made” $100,000 on your investment, you have limited options for pulling that money out. Private investments are often characterized by low liquidity, as stakes sometimes can’t be sold or may be controlled by lock-up periods. By contrast, if you decide you want to pull $50,000 out of an account primarily invested in stocks, you can access your funds more quickly.
Ease of administration: Standardization in public markets means that tax reporting can be consolidated across platforms into single forms, and setting account beneficiaries is decently straightforward. For many private investments, their one-off characteristics can leave you hunting down paperwork, frustrating your accountant and potentially confounding any heirs.
And when you click into some of the generalizations in favor of private investments, the opportunity for emerging-wealth investors seems less obvious:
Diversification - in your portfolio, or just on paper?: Investors may be interested in privates because of their potential for diversification: by behaving differently from public markets, they can reduce the correlation in your portfolio. However, while public investments are re-priced constantly through the day while they trade on a market, private investments (like your house, but also private companies, private funds, large buildings, etc.) are only valued irregularly, and based on appraisals that may include significant judgment. This “appraisal lag” can exaggerate the diversification benefit of private investments.
Higher returns – but for whom?: Performance for private investments is frequently discussed at the level of the entire asset class; consider this advertisement for Arta: “Private equity managers significantly outperform public markets.” However, here we again hit on the “Africa’s a pretty big place” problem. Average returns for an entire asset class can be heavily skewed by top performers, who often restrict investment to the largest and most sophisticated investors (e.g,. pension funds.) The Wall Street Journal recently profiled startup companies that seek funding on crowdfunding sites rather than seeking institutional capital; these firms were more likely to be cash-flow negative and to feature poor governance practices.
Accessed September 22, 2024
However, the marketing message that personally grates me the most is that individuals should invest in privates so that they can “invest like billionaires.” First, billionaires have a very different investing profile from the average wealthy household investing for retirement: their tax needs, time horizon, market access and others are very different. But I also take umbrage at the idea that something fancier is inherently better: sure, Tom Brady may take some obscure supplement, but presumably he also avoids processed foods and exercises several times a week – basic steps that would get most Americans further than emulating his bells and whistles. And finally, there’s just the factual error: publicly-traded ETFs are good enough for at least some prominent billionaires. The Walton Investment Trust manages more than $5 billion primarily in ETFs and individual stocks, and Warren Buffet has instructed that he would like his wife to invest 90% in low-cost ETFs after he passes away.
Accessed September 23, 2024
Of course, private investments have a time and a place, and your specific resources and the specific opportunities available to you may vary greatly. Because private investments can be more hands-on, many people enjoy using “play money” — a smaller portion of a portfolio they can afford to lose — to take self-aware bets with private investments.
However, generalizing broadly, for those who are still working on saving and investing their first million dollars, and don’t find the diligence of private investing rewarding for its own sake, I tend to suggest they stick with the public markets.
Author: Caitlyn Driehorst
Date Published: 9/23/2024
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