My Top 5 Worst Investments… #4
It’s been a while since I brought my readers an example of one of my own personal car-crash investments!
This edition of My Top 5 Worst Investments doesn’t relate to any specific investment per se.
I’m talking here about a broader type of deal that everyone will be tempted by at some time or another.
I know with certainty, that for some of my readers, this edition of Peter’s Perspective will save them tens if not hundreds of thousands of dollars…
Tama and I often get approached by all sorts of people looking for investor dollars.
It could be venture capital (a new concept/idea from an entrepreneur or a small company looking for financing).
Or it could be private equity (perhaps a more traditional business where you are buying into more mature companies).
At one end of the spectrum, we have the more modest business ambitions.
Maybe it’s a food & beverage play, someone looking to import and distribute a product or service, a small tech startup, a new app… the list goes on.
[A reminder here why you should never invest in F&B!]
These meeting requests typically come through friends, old acquaintances, former colleagues and the general grapevine.
Normally you’re looking at an investment size of anywhere from US$25k to US$100k.
At the other end of the spectrum, we have the more ‘professional’ grade of private equity. It could be a Chinese factory, a European bioscience private equity fund, an appliance manufacturer… anything.
In these cases, the ticket size is larger (think US$100k to US$250k) and the opportunity is wrapped in a more standardized private equity vehicle.
I’m pretty sure that in the past twelve months you’ve been approached by someone pitching you an opportunity somewhere in the spectrum described above.
[Let me point out here that I have some experience with raising capital myself. I spent a lot of time raising money for the real estate hedge fund (since closed) that I set up in 2004. And I continue to spend a lot of time raising money for our local real estate private equity vehicle today.]
Now, what I’m about to say will make me highly unpopular to many people… and I could be shooting myself in the foot as well, but let me be clear:
Most individuals have absolutely no business whatsoever ‘investing’ in either of these types of private enterprises – either the small deal, or the larger traditional private equity deal.
I’m absolutely serious. And here’s why.
Imagine your total personal wealth asset allocation pyramid.
At the bottom of the pyramid you have things like cash, savings accounts, vanilla life insurance… money market accounts.
Low risk. Low volatility. Your foundation.
Moving up you have fixed income… bonds, maybe some preferred stock.
Low-ish risk. Income.
[I’d also put real estate (that you live in) in this category as well.]
Higher up the pyramid come your big blue chip stocks… and gradually moving to emerging markets, currencies and smaller cap equities… and finally things like options, maybe futures.
Our allocations of wealth to each part gets smaller as we move up the pyramid.
And right at the very top… in the ‘highest risk with lowest liquidity’ category… you have venture capital and private equity.
Now, I think you know that part of the pyramid should have your lowest overall allocation!
Deep down it makes total sense to you.
I asked a Financial Advisor friend of mine, Todd Pallett at EXS Capital, what he recommends as an allocation to this part of your pyramid.
“You should limit your VC or PE investments to no more than 5% of your net worth at a maximum.
That means if you’re going to write a fifty thousand dollar cheque, you shouldn’t have anything less than a million bucks in net worth.
If it goes to the moon then great, you might wish you did more!
But in my years of experience with clients, it’s much more likely it won’t. And you’ll be very happy you kept a sensible risk limit.”
When you stop and think about it for a moment, just take a look at what characterizes these kinds of private capital investments.
They’re Totally Illiquid
If you sign a US$50k or US$100k cheque, you better believe you’re not going to see that money again any time soon.
It will be YEARS before there’s any kind of exit for you. That cash is tied up.
Unless the company IPOs or gets bought out, then you’re stuck. You might book some paper profits if there are later funding rounds at higher valuations.
But rest assured, you need to be willing to sit, watch and wait.
Take it from Warren Buffet. Cash is King. And he keeps plenty of it on hand.
We keep a lot of cash on hand “so that we can both withstand unprecedented losses and…quickly seize acquisition or investment opportunities”
If too much of your wealth is tied up in illiquid investments, then you can’t move quickly when the really great opportunities come along.
As they say, when “there’s blood on the streets” it’s time to buy… (or sell mops).
Say No to the “FOMO”
Let me guess, the opportunity sounds great. It’s exciting. All your friends are all piling in.
You get a little adrenalin rush thinking about how you’re going to spend your newfound riches…
You DO NOT want to be that one guy who didn’t buy the winning lottery ticket. The guy who missed out on the big score.
How will you live with yourself if you’re still sat behind your desk while your buddies are sitting on their yachts sipping Mai Tais?
Please, ignore the Fear Of Missing Out (FOMO).
We all get it… myself included. But it’s a terrible, terrible reason to invest.
Your Odds Are, By All Accounts, Terrible
The media loves stories about the folks who bought in to Twitter or Facebook in the early days. The investment buccaneers who struck gold…
But rest assured, for every unicorn, there are at least 99 donkeys who end up at the knackers yard…
For the vast majority of us, it ain’t gonna happen.
Don’t get me wrong, your winning numbers might come up… but that doesn’t make buying a lottery ticket the right idea.
I could go on and on… the lack of control, corporate governance issues, transparency…
The point I’m trying to make here is this: there IS a place in your portfolio for these kinds of investments, but the biggest single mistake I see people making is allocating way too much money towards them.
I know plenty of people who don’t own a stock, or a bond, or even real estate… yet they’ve put low to mid six-figures into venture capital and private equity!
Remember: these investments are the LAST thing you look at, not the FIRST!
Get everything else in place to begin with.
Make sure your pyramid is properly structured.
Then, and only then, dive into the illiquid stuff… and get your allocation right.
And when it comes to these investments, there’s a long list of things you need to check off before you hand over a single dollar.
I’ll share my check-list with you another time.
I’ve had plenty of painful experiences and hopefully sharing my mistakes will help you avoid making the same ones.