It may seem surprising, but one of the biggest challenges facing many investors is the social pressure from their community and circle of friends. It’s quite common for people to exhibit conformity bias — where they behave according to, and make decisions based on, what others around them deem acceptable. However, adapting your investment approach to be similar to that of your friends and family can be detrimental to achieving your financial goals, since every person’s goals and financial situation are different.
From my experience, wealthy investors are the most susceptible to falling into the conformity bias trap. Looking at their portfolios quickly confirms this. There are certain investments that are more easily accessible to high-net-worth individuals. Those opportunities sound exclusive, exotic and generally require high initial investment minimums in order to participate. They also make wonderful conversation at the country club, golf course or other venues that may attract a similarly affluent clientele.
Unfortunately, many of these more exciting investments make sense for only some investors and typically should not represent more than a small portion of one’s overall portfolio. It is generally ill-advised to have your entire nest egg tied up in these strategies. Below are some examples of these investments that can be found in the “country club portfolio.”
Private Equity (PE)
PE funds typically invest in companies that are not publicly traded. Some common examples are venture capital and leveraged buyout funds. Most PE firms are exclusively open to high-net-worth investors.
While there is the potential for high returns, investors need to be comfortable parting with their money for an extended period of time, sometimes between five and 10 years, while the strategy is implemented. In addition to the lack of liquidity, there is the possibility that the investments won’t work out or will substantially lag the public markets.
Hedge funds are actively managed pools of capital whose managers use a wide range of aggressive strategies to deliver outsized returns. This may include using borrowed money to make investments and trading more esoteric assets.
In recent years, hedge funds have been broadly criticized for their high fees and lackluster returns relative to the overall market.
Real Estate Syndication
Real estate is a wonderful asset class with which many investors are familiar. One way to get exposure to this area of the market is through a real estate syndication, where investors pool funds to purchase income-producing properties. The success of these types of deals depends on the location of the opportunity, type of property, management of the project, and experience of the deal manager.
It’s important for an investor to do their own due diligence of all those factors to increase their likelihood of success.
Hard Money Loans
A hard money loan is money lent by an individual or company instead of a bank. They are known as a loan of last resort, often a short-term way to raise money quickly for individuals denied traditional financing. As a result, the yields are often much higher than on loans through traditional channels.
Hard money loans generally rely on collateral rather than the financial position of the applicant. Consequently, a default by the borrower may still result in a profitable transaction for the lender through collecting of the collateral. This method of financing carries a high level of risk.
Initial Public Offerings (IPOs)
An IPO is the process of offering shares of a private corporation to the public through a new stock issuance. There is a lot of excitement when a popular company comes to market, allowing investors to own shares of it. There is even more enthusiasm among those who can buy the stock before the general public.
Unfortunately, all the exuberance creates a tendency to make bad decisions, such as purchasing a company without doing your own proper due diligence, or short-term trading to try to lock in an immediate profit. These behaviors won’t contribute to achieving long-term success.
If you are fortunate enough to participate in an IPO, it’s far more prudent to know what you own, why you own it, and to hold the company for the long-term.
Instead of a Country Club Portfolio, Go Back to Basics
When discussing the above strategies with friends, it’s common for folks to emphasize the sizzle and not the steak. Everybody will share the exciting features of these strategies and their exclusivity. However, few will share their overall success with all their exotic strategies and how it compared to a simple portfolio of stocks, bonds and cash.
Some investors would be far better off focusing on the below tried-and-true methods that drive one’s ultimate financial success.
Have a Solid Overall Asset Allocation
When investing, there is a temptation to get caught up in the details of trading, security selection and market timing. However, the reality is that one’s exposure to different asset classes, including stocks, bonds, real estate and cash, is far more determinant of returns than the aforementioned items. In fact, a 1986 paper by Gary P. Brinson, Randolph Hood, and Gilbert L. Beebower titled “Determinants of Portfolio Performance” published in the Financial Analysts Journal concluded that asset allocation explained 93.6% of the variation in a portfolio’s returns.
The first step in designing a sensible portfolio is to get the big picture correct, and that starts with proper asset allocation.
Watch Your Fees
In today’s world, U.S.-based investors can get exposure to investments all over the world for a minimal fee. Utilizing easily accessible exchange-traded funds or low-cost mutual funds are some of the best ways to obtain that global exposure. While some wealthy folks may turn up their nose at such pedestrian investments, the reality is that high fees eat away away at one’s returns and will hinder their ability to achieve their goals.
An investor should think long and hard before paying a money manager premium prices for an investment that they can get similar exposure to for a modest fee in a traditional investment vehicle.
Invest with Taxes in Mind
Another drag on the overall performance of one’s investments are taxes. Focusing on where to locate certain investments, whether in a tax-deferred or taxable account, can add up to real money over a long time horizon.
For example, tax-inefficient investment strategies with lots of trading, real estate investment trusts, or securities that pay non-qualified dividends should be located in an IRA. This will mitigate an investor’s tax liability. Conversely, tax-efficient investments like index funds, growth stocks and municipal bonds can be placed in a taxable account, since the tax burden will likely be more modest.
A focus on how taxes impact returns should be a top priority to enhance performance over time.
Know the Difference Between Deep Risk vs Shallow Risk
Dr. William J. Bernstein, a financial writer and retired physician, describes the distinction between deep and shallow risks. Shallow risk is the loss of capital that recovers within several years, while deep risk is the permanent loss of capital.
A good example of shallow risk is investing in the broad U.S. stock market. You can experience a short bear market, like what we saw in March 2020 when the S&P 500 dropped approximately 34%, but ultimately the U.S. market will recover. Shallow risk can be expected to occur somewhat frequently, but it can be managed with proper planning techniques like diversification, maintaining sufficient cash on the sidelines, and sticking with a strategy for the long haul.
Deep risk may be associated with some of the investments within a “country club portfolio.” This includes the default on a hard money loan or bankruptcy of an early-stage company shortly after an IPO. It can also occur if a real estate deal falls apart or a particular money manager is practicing creative accounting to artificially increase returns. In these scenarios, the investor may not get any of their investment capital back, and their loss will be permanent.
The above considerations won’t generate the excitement of a “country club portfolio.” However, conforming to the crowd is generally not an optimal way to go through life. When it comes to financial planning and investing, sticking to the basics, and keeping things simple, is almost always the best approach.
Disclaimer: This article authored by Jonathan Shenkman a financial adviser at Oppenheimer & Co. Inc. The information set forth herein has been derived from sources believed to be reliable and does not purport to be a complete analysis of market segments discussed. Opinions expressed herein are subject to change without notice. Oppenheimer & Co. Inc. does not provide legal or tax advice. Opinions expressed are not intended to be a forecast of future events, a guarantee of future results, and investment advice. Investing in securities is speculative and entails risk. There can be no assurance that the investment objectives will be achieved or than an investment strategy will be successful. Investors must carefully consider a fund’s investment objectives, risks, charges and expenses of the investment before investing. This and other information, including a description of the different share classes and their different fee structures, are contained in a fund’s prospectus. You may obtain a prospectus from your financial professional. Please read the prospectus carefully before investing. Adtrax #: 3882001.1
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
Associate Director – Investments, Oppenheimer and Co. Inc.
Jonathan Shenkman is a financial adviser, portfolio manager and the founder of the Shenkman Private Client Group of Oppenheimer & Co. Inc. He is experienced in developing creative strategies that allow his clients to achieve their retirement, estate and philanthropic objectives.