Since the financial crisis of 2007-2008, the U.S. stock market has been booming. The S&P 500 more than tripled from 2009 to 2017, and was hitting all-time highs as recently as January. During bull markets like this, investors may be tempted to pile into risky investments in search of even more gains.
One area performance-hungry investors may look is non-publicly traded investments—a category that includes venture capital, private equity and initial public offerings (IPOs). When investors are full of confidence and flush with cash, they're more willing to ignore the significant risks associated with these types of investments. The people pitching these offers, of course, understand that the best time to search for backers is when the markets are hot and demand is high.
While the potential upside of these investments is huge, they are also unpredictable, opaque and in many cases dangerous. That's why it's so important for investors to exercise caution when considering private offerings.
Why bull markets bring more risky opportunities
When markets are doing well, it can seem like the opportunities to invest in startups and other private companies multiply. This is no illusion. A thriving economy produces a lot of capital, and—especially when combined with low interest rates—that leads to entrepreneurs and business owners taking more risks than they otherwise might. In 2007, for example, the number of startups exceeded 500,000, but in 2010, in the wake of a deep recession, that number dipped below 400,000. IPOs followed a similar pattern, plunging from 159 in 2007 to just 21 the following year.
With so many opportunities during a bull market, it can be tempting to invest in these risky ventures. Investors who are doing well may look around and see others who are doing even better, and it's human nature to want to keep up.
What's more, there's a lot of excitement surrounding new businesses. With no track record to back them up—or weigh them down—entrepreneurs are able to convey a sense of infinite possibility. Even investors who are already enjoying strong returns are liable to be tempted to buy in to investments with no apparent ceiling.
What makes private investments risky?
Private equity, IPOs and venture capital can bring high returns for investors. But they also come with risks, including:
- Long and unknowable investment horizons. Every startup has a plan to succeed, but none can promise how long it will take to achieve the success they envision.
- Low liquidity. While individual stocks, mutual funds and other assets can often be sold off in a matter of days, private equity investments often requires investors to leave their money in the business for several years. The average requirement is between four and seven years, but many investments take even longer than this to show returns—if they ever do.
- High bankruptcy rates. Private equity suffers from high bankruptcy rates compared to other investment classes. What's more, since they're often focused on creating prototypes, many private companies invest little in physical equipment, making it hard to recover initial investments in the case of bankruptcy.
- Lack of transparency. Compared to publicly traded companies, there are far fewer requirements for private firms to divulge information regarding performance and asset valuation to their investors. Additionally, many startups see an advantage in remaining secretive about these figures.
- The unique risks of IPOs. The excitement surrounding IPOs often drives share prices higher when the stock debuts. As time passes, however, this excitement often wanes. Newly public companies are subject to a variety of new pressures and regulations, and this can erode their value over time.
A small investment can be a big risk
Even a relatively small investment in private companies can propel investors toward a dangerous risk profile. For example, say you invest 5%–10% of your portfolio in private equity investments and IPO shares, and the rest equally into stocks and bonds. The result, from a risk standpoint, could be roughly equivalent to a portfolio that's 100% invested in stocks.
Another common misconception: Private equity investments often are considered good ways to diversify a portfolio, in part because they appear to have low correlations with publicly-traded equity markets. But these correlations largely reflect estimated returns, which can't be realized by investors. The returns that can be realized are highly correlated with public equity markets, making them far less useful as diversification tools.
Investing in venture capital, private equity and IPOs is a bit like playing the lottery: you might win big, but the risks are very real. Please contact us if you have questions about your portfolio's risk or complete our free portfolio risk analysis. If you would like a second opinion on your portfolio, please contact us to schedule a meeting or click here.
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail firstname.lastname@example.org.
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