- In recent years, the negative correlation between public stocks and bonds has broken down, limiting the benefits of diversification.
- Large institutions have looked outside public markets for diversification for decades, while individual investors have been largely shut out from the same opportunities.
- Recent changes in technology and regulation have opened up the world of private investments for individuals.
Today’s public markets move at the speed of light – literally. Trades to rebalance portfolios and take advantage of new opportunities can be executed in a few keystrokes and the blink of an eye. Passive investors can rest easier than ever knowing that advanced algorithms are employed to refine their portfolios. But despite these improvements, one constant remains: risk, and the desire to avoid it. This is true for every investor looking to increase financial stability and protect against market downturns.
The most common way to mitigate risk is through diversification: the idea that it’s best not to put all of your eggs in one basket. Unfortunately, attempts at diversification through public market investing alone have become less effective in recent years due to a rise in correlations between public investments.
The solution is to look outside of the public markets entirely, and instead turn to private investments, or investments not traded on a public exchange. Many multi-billion dollar institutions and high-net-worth individual investors have followed this strategy for years, by allocating significant portions of their portfolios to assets such as private equity, hedge funds, venture capital, and real estate. Moreover, these investors have been significantly growing their private market holdings of late. Unfortunately, most individual investors have been largely left out of this wave of private market investing. Why?
Access and Education
Individual investors don’t deserve the blame for not trying to invest outside of public markets sooner. Two prevailing forces have kept individual investors from seeking diversification in private markets: regulation and education.
Many private market alternative investments have high regulatory barriers, such as the need for investors to be “accredited”. Today, an accredited investor in the United States must generally have an annual income of $200,000, joint income of $300,000 or net worth of $1 million, which represents only about 10% of US households. This greatly limits the number of investors who can invest in most offerings not listed on a public exchange.
On the education side, economist Harry Markowitz introduced “Modern Portfolio Theory” in 1952, and it has served as the prevailing model for how individual investors should build their portfolios ever since. His theory has been distilled by others and spread widely to the public as something akin to the following: An investment portfolio should be a balance between publicly-traded stocks and bonds, starting with a ratio of 70:30, transitioning away from stocks and into bonds as the investor gets older. The prevailing personal finance wisdom of today says that this allocation to public equities is thought to offer sufficient diversification across geographies, industries and firm-specific risks, while bonds are generally believed to further mitigate risk through an inverse correlation with stocks.
In recent years, the beneficial inverse relationship between public stocks and bonds has broken down, with rising correlations between the two diminishing the value of this mild form of diversification. Moreover, the rise of index investing and advances in trading technology – among a host of other forces – have increased correlations between publicly-traded stocks. Hence, a portfolio allocated only to public stocks and bonds risks dramatic losses in a downturn. One solution is to look outside of public markets entirely for a way to mitigate this risk.
Portfolio Theory 2.0
Many of the most successful institutional investors have consistently protected their downside and earned higher returns by adding private market assets like real estate to their portfolios. For example, the private investment holdings of the California Public Employees’ Retirement System generated 20-year annual net class returns of 12.3%, compared with 8.2% for its public equity holdings.
Meanwhile, institutions continue to grow their private market allocations. A recent Pew study found that public pension plans have more than doubled their alternative investment allocations over the past decade – from 11% to 25%, on average.
Taken together, this suggests that private investments may boost portfolio performance while mitigating risk. Of course, there is a tradeoff. Individuals who invest in private markets give up short-term liquidity in exchange for the higher potential returns. But for many investors (including younger investors with relatively long time horizons), sacrificing some liquidity in exchange for mitigated risk and higher potential returns is a trade-off well worth making.
Unfortunately, in the past this was a trade-off most retail investors didn’t have the option to make even if they desired to. However, a seismic shift is underway thanks to the advent of new technologies, which are making private market investments more accessible than ever before.
Access Through Technology
Recent regulatory changes have finally made private investments more widely available. For example, Fundrise has built the first private market real estate investment platform, making it possible and efficient for the everyday investor to build a portfolio like the most sophisticated, multi-billion dollar investment funds. Fundrise gives individual investors a way to invest in diversified portfolios of US private market real estate, all online.
Other technologies include platforms for peer-to-peer lending, as well as the recent rise in cryptocurrency which allows individual investors access to ICOs (initial coin offerings) that skip the private venture capital stages. Of course, these investments carry a lot higher risk thresholds which make them much less viable as investment vehicles for a majority of people, but regardless it’s time for the technologies that have improved public markets for the individual investor to help them go private as well.
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