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FORECASTS & TRENDS E-LETTER 1. SEC Plans To Raise “Accredited Investor” Definition 2. Why The SEC Thinks A Change Is Necessary 3. Pros And Cons Of The Proposed Change 4. What The Wealthy Know That You May Not Know 5. Managing Risk And Expectations Introduction Most of you reading this are at least somewhat familiar with the term “accredited investor.” In 1982, the Securities & Exchange Commission established that individuals with a net worth of $1,000,000 and/or annual income of at least $200,000 ($300,000 for couples filing jointly) for the two previous years qualified as accredited investors. For good or bad, the SEC’s action deemed anyone exceeding the net worth or income thresholds financially astute enough to evaluate more complex investments. As a result, accredited investors may be offered certain securities and investments that are not generally available to non-accredited investors. Many so-called “alternative” or “private” investments are only made available to accredited investors, including many hedge funds, futures funds and other sophisticated investments. This doesn’t mean all such investments are automatically suitable investments for accredited investors, but they do get to look at more investment options than non-accredited investors. In December of last year, the SEC proposed to increase the accredited investor net worth requirement from $1,000,000 to $2,500,000. Plus, the old $1,000,000 standard allowed accredited investors to include the value of their primary residence, but the new standard will specifically exempt this asset. If the new standard is adopted, as is expected, the number of accredited investors will suddenly plummet. The SEC’s own press release back in December estimated that the new “accredited natural person” definition, if adopted as proposed, would significantly reduce the number of US households that are eligible to invest in private investment vehicles. By the SEC staff’s calculation, apprx. 8.47% of US households currently qualify for accredited investor status at the $1 million net worth level. However, the SEC estimates that this percentage would drop to only apprx. 1.3% of US households at the $2.5 million threshold. So potentially millions of investors will no longer qualify for certain investments should the new rule take effect. And the new rule, if approved, could go into effect at any time. As noted above, the SEC proposed the new rule change in December of last year and requested comments from the investment industry and the public. The comment period ended on March 9 of this year. Thus, the new $2.5 million threshold could be announced at any time now. Why The SEC Thinks A Change Is Needed According to the SEC’s December 2006 Proposed Rule, the revisions to the accredited investor standard are designed to help ensure that purchasers of private investment vehicle securities continue to be capable of evaluating the merits and risks associated with such investments. As noted above, the current $1 million threshold to qualify as an accredited investor was adopted in 1982, and it has not been adjusted upward since then despite years of inflation. The SEC’s view is that inflation, coupled with increasing home values, have allowed many investors to qualify as accredited that otherwise would not have done so. Thus, they feel the standard should be increased significantly to protect investors. A second reason for a change found in the SEC’s announcement is that the private investments reserved for accredited investors have become increasingly complex over the years, much more so than in 1982. The increased complexity, added to the lack of information on many of these strategies from public sources, led the SEC to propose higher net worth limits for accredited investors. With the stated intent of the proposed rule change being to protect investors, I find it curious that the SEC specifically exempts “venture capital” offerings from the new $2.5 million net worth requirement. As the name implies, venture capital funds typically provide capital for start-up firms, which can be just as risky as many hedge fund strategies (or maybe even more so). The SEC states the reason for exempting venture capital funds in its release: “…we recognize the benefit that venture capital funds play in the capital formation of small businesses.” While I’m all for funds that provide capital to new start-ups, I find it hard to justify the exemption of venture capital funds in light of the SEC’s stated purpose of protecting investors from increasingly complex private investment offerings. Pros And Cons Of The Proposed Change As usual, there are two arguments – for and against – a substantial increase in the accredited investor net worth requirement. The argument against such a large increase tends to focus on the issues of sophistication and suitablility. In the SEC’s view, apparently, individuals with very high net worths are likely to be more sophisticated, when it comes to evaluating investments, than those with lower net worths. On paper, this would seem to make sense – those with more money should be more sophisticated. Yet I would point out that this is certainly not always the case. In my 30+ years in the investment business, I have met or spoken with many individuals who have a lot of money but who are certainly not sophisticated when it comes to investments. This is often the case with people who have just inherited a lot of money, or individuals who have just sold a business for a large sum of money, or the survivor upon the death of a spouse. The point is, there are plenty of people who have a net worth of $1 million, or even $2.5 million, that are not sophisticated investors. On the other hand, I have also met or spoken with many individuals over the years that were very sophisticated investors, even though they didn’t have a $1 million net worth. In my opinion, there are plenty of investors who are capable of evaluating the merits of sophisticated investments even though they do not have a net worth of $1 million, much less the $2.5 million which is likely to become the new accredited investor requirement. Much the same argument can be made on the issue of suitability. We’ve all seen the standard disclaimer. . . if it is suitable in terms of your financial position. . . or something similar to that. Sellers and distributors of most investment products are required to attempt to determine if those products are suitable for the investors being solicited. If you have invested in very many things, you know that net worth is frequently one of the main determinants of suitability. Here again, is a carefully selected hedge fund or futures fund suitable only for those with a net worth of $1 million, or maybe soon to be $2.5 million? Not necessarily, in my opinion. Investors can have well-diversified portfolios with less than $1 million, and certainly less than $2.5 million. And a decision by such investors to diversify a small portion of their portfolio in so-called “alternative investments,” which are often not highly correlated to traditional investments such as stocks and bonds, could potentially be a wise decision. But if the SEC adopts the new $2.5 million threshold, millions of investors will not have that option. Sellers and distributors of private investments will not be allowed to show them to investors who do not meet the new standard (perhaps with some limited exceptions). The Millionaire Next Door The arguments in favor of increasing the net worth requirement are limited, and are generally only voiced by the SEC and other regulatory bodies. However, there were some comments made in favor of certain aspects of the change, even from major industry groups. The most common reason given for being in favor of the increase is that the original $1 million net worth requirement was established 25 years ago in 1982 and has never been increased. When you consider inflation, it’s not hard to see that $1 million in 2006 is worth nowhere near what is was in 1982 when the accredited investor standard was first established. For example, if you go to the Bureau of Labor Statistics’ inflation calculator (at http://data.bls.gov/cgi-bin/cpicalc.pl), you’ll see that $1 million in 1982 would be equal to $2,089,119 by the end of 2006 when adjusted for inflation. Thus, proponents of the new accredited investor standard argue that the increase is justified. According to a study released in 2006 by the Spectrem Group, there are a record 8.3 million millionaire households in the US (excluding primary residence). Even though other studies come up with different numbers of millionaires, it is still quite clear that the number of households with a $1 million or greater net worth has significantly increased in recent years. Supporters of the SEC proposal to increase the net worth requirement for accredited investors say that much of this increase has come from retirement account assets and residential real estate increases, and not from sophisticated investing. While it’s true that 401(k) plans generally allow participants to direct their own investments, the choices are typically limited to a variety of mutual funds and not more complex investment strategies. To the SEC’s credit, I think it fair to assume that a significant number of the current millionaires in the US are not sophisticated when it comes to evaluating investments in general, much less many of today’s complicated private offerings. However, to exclude the primary residence and raise the net worth requirement above where it would have been if indexed to inflation is overkill, in my opinion. The bottom line is, the SEC is very likely going to raise the accredited investor definition from $1 million to $2.5 million (excluding your residence) very soon. If that happens, most private and alternative investments – including most hedge funds, futures funds and others – will be off limits to those with net worths below $2.5 million. If you are an accredited investor under the current definition, but do not meet the $2.5 million proposed threshold, you may not have much time left to make a decision on investing in such privately offered investments that you may have been considering, before the door is shut. What The Wealthy Know That You May Not Know All too often, wealthy investors are seen as having access to super-secret investment alternatives unavailable to everyone else. And it’s unfortunate that this perception is helped along by shameless investment promotions offering to share these secrets with unwary investors – for a price, of course! While I discussed above how certain types of investments are unavailable because of net worth requirements, most of the strategies are hardly a secret. Literally hundreds of books, articles and web pages are available to explain alternative investment strategies. However, even though there are few “secrets,” there IS a lot that you can learn from the way many wealthy people approach investing, especially in regard to managing risk. It has been my experience that the primary characteristic that sets many successful wealthy investors apart from the average investor is their interest in “absolute returns” rather than “relative returns.” The reasons for this are fairly straightforward. Wealthy individuals are usually keenly aware of their wealth and the freedom and lifestyle it affords them. Thus, wealthy individuals are usually more interested in protecting their wealth than swinging for the fence to build even more wealth. Not meeting goals for investment growth would be bad news to a wealthy investor, but losing their financial independence would be devastating. Average investors, however, have not yet reached the ranks of the financially independent, so they are more concerned about investment growth than about losses, in most cases. The wealthy, as a general rule, do not necessarily have this concern unless their lifestyle is such that they can burn through their entire fortune in their golden years. Thus, in my experience, the main difference between how a wealthy investor approaches the market versus an average investor has nothing to do with secret strategies, and everything to do with mindset. In other words, many wealthy investors have a different mindset toward investing than most average investors, in my opinion. It is different in that most of the very wealthy know that they are set for life UNLESS they make a major mistake. Can such mistakes happen? You bet! Here’s an example: Over the years, we have been approached by a number of prospective investors who worked for major high-tech companies. In the go-go 90s, they had accumulated multi-million dollar portfolios of their employers’ stock, only to see its value implode as the tech bubble burst. At that point, several of them decided to diversify and put the money with large brokerage firms. In some cases, unfortunately, these Wall Street firms disregarded their need to manage risks, and these investors ended up losing even more money. The end result is that these individuals are no longer wealthy. Our calculations showed that the net worth of one of these formerly wealthy individuals had shrunk 90%! Horror stories like this are, unfortunately, not uncommon among wealthy investors, especially those who find themselves “suddenly wealthy” from stock options, an inheritance, or selling a business. That’s why those who counsel wealthy individuals typically place a high priority on preservation of capital, more so than building substantially more wealth. The desire to maintain wealth is also a big reason why many wealthy individuals flock to hedge funds. Today, the hedge fund industry is viewed as being populated by speculative ventures, but this was not always the case. Early hedge funds were developed primarily to reduce the risk of being in the market, by using short positions to reduce losses in a down market. The definition of a “hedge” is to reduce the risk of loss. Many hedge funds also use “absolute return strategies” that have the goal of making money in both up and down markets. I have written in detail about absolute return strategies my Special Report.
Even though the interests of wealthy investors are not always necessarily aligned with those of the average investor, there are a number of principles and strategies employed by many wealthy investors that do apply to virtually anyone who seeks to invest for the future. Above, and in my Special Report, I discuss the concept of absolute returns. How and why absolute returns are generated comes down to the management of risk. While we all know that past investment returns are often a poor predictor of future returns, a recent Morningstar study has shown that measurements of past risks are more likely to predict future risks. Morningstar stated, “[The] relationship between past risk and future risk is stronger than that between past return and future return.” (Morningstar.com, “Risky Business”) I frequently write about risk management and preservation of capital in these E-Letters. The most common example I use to illustrate the importance of avoiding large losses is what I call the “Breakeven Table,” showing how much it takes to recover from various levels of loss. For example, a 20% loss requires a 25% gain to recover; and a 30% loss requires 43% to get back to breakeven. During the 2000-2002 bear market, the S&P 500 Index plunged almost 45%, and anyone who stayed in an S&P 500 index fund during that period suffered the same downhill ride. Those investors had to make an 82% cumulative investment return just to get back to where they were in early 2000, before the start of the bear market. This is precisely why I do not recommend that investors have most of their money in passive buy-and-hold strategies or index funds. Just as important as the losses that were incurred by buy-and-hold investors, there is also the “time factor” to consider. It took the S&P 500 Index over seven years to return to where it was at the peak in 2000. Seven years of treading water is a very long time to lose in any financial plan. But here’s the absolute worst part: many investors bailed out of the market completely near the bottom in 2002, and have never gotten back in. Many have missed the market’s recovery, and now find themselves, as the old saying goes, up a creek without a paddle. Managing Expectations & Being Realistic Another factor that wealthy investors have going in their favor is that they are generally better able to manage their investment expectations. Obviously, this is a broad generalization and not every wealthy investor is so inclined, but it has been my experience that most successful wealthy investors have a very realistic outlook in regard to their potential future investment returns. I attribute this realistic outlook toward returns to the fact that most wealthy investors work with professionals in the financial services business, rather than forming their expectations based on the hype in the financial media, an arbitrary market index, or some other rule of thumb. As I noted above, wealthy investors tend to want to minimize the chance of losing substantial portions of their wealth. However, they also do not want the purchasing power of their fortune to decline due to inflation. In addition, most wealthy individuals want to see their wealth grow at a reasonable rate over time, whether it be to pass on to heirs, fund a foundation or charity, or other desires. Thus, “risk-adjusted returns” are the order of the day. However, risk management usually comes at a cost of giving up some of the market’s return. Using the hedge fund example, if part of the account is dedicated to hedging the portfolio, it just makes sense that the investor will not participate in 100% of the gain of the securities held long in the portfolio. The same goes for “active management” strategies that can go to cash in down markets. Rarely do money managers get out at the very top or buy in at the very bottom (no one does), so some potential returns are “left on the table,” so to speak. However, in light of the value of risk management, many wealthy investors are comfortable with the tradeoff. All investors could learn a lesson from the wealthy in this respect. Many investors base their investment return expectations on outside factors that have absolutely nothing to do with their individual goals and risk tolerances, and this is big mistake. Even some financial professionals will use historical market averages to set expectations. However, historical return numbers can be manipulated by selecting a time period that helps prove a point. For example, anyone who invested in the 1990s got used to market returns in the 20% to 25% range, and some investors still believe that 20-25% returns ought to be a reasonable expectation. However, someone who lived through the sideways markets of the late 1960s through the early 1980s would argue that double-digit returns on certificates of deposit are far better than the virtually flat performance of the stock market. It’s all a matter of perspective, but unfortunately, the only perspective that counts is what the market is going to do in the future, and no one knows what that may be. Goal-Based Expectations Whether you are managing a family fortune or the money in your employer’s 401(k) plan, it is important to base your return expectations on your overall investment goals. I am constantly amazed at how many prospective investors will contact us for a review of their portfolio, only to find that they have invested far more aggressively than is required to meet their goals. Many investors have no idea what kind of return it will take to meet their investment goals, so they swing for home runs in the stock market when singles and doubles would do just fine. If you have done a good job saving for retirement, children’s educations, long-term care, etc. and you only need a moderate level of return to meet these goals, why subject your portfolio to substantially more risk than it will take to potentially produce this level of return? In light of what we have seen in the markets over the last five or so years, including the bear market of 2000-2002, effective risk management is critical to achieving your goals. If you don’t heed any other advice I provide in this article, make sure you do this: Determine what level of investment return is necessary to meet your financial goals, and invest accordingly. Whether you use my firm, a local financial planner, or even Internet resources, it is important to know what kind of investment returns are necessary for you to meet your goals. Any other expectation, whether from the financial media, investment company promotions, or wherever, cannot substitute for this knowledge. What Is Your Time Worth? It has also been my experience that many wealthy individuals use the services of financial professionals rather than managing all of their investments themselves. That doesn’t mean they don’t closely monitor the professionals they engage, but rather that they have better things to do with their time than pore over financial data and watch the markets all day. In short, the wealthy tend to make their money work for them, rather than the other way around. Most investors have better things to do with their time than micro-manage their own investment accounts. While some investors greatly enjoy researching markets and trading their accounts, most everyone else would rather focus on their career, spend time with family, engage in a hobby, or volunteer their time to a good cause. Unfortunately, the financial media coupled with the wealth of information on the Internet have gone far in convincing the investing public that not only can they do it themselves, they should do it themselves. For those who are so inclined, I would say “go for it.” But, for the rest of you who would rather spend your time doing something else, I strongly recommend the use of carefully selected professional investment managers. After all, you can get information on the Internet about home cures and sample legal documents, but most people don’t use this resource rather than going to the doctor or seeing a lawyer when the need arises. I think the same goes for financial professionals, and I have put my money where my mouth is. In my latest Special Report, you will learn about the AdvisorLink® Program developed by my company in 1995. The purpose of this program is to introduce my clients to successful Investment Advisors whose goal it is to provide attractive risk-adjusted returns. Many of the strategies employed by these Advisors are similar to those used by hedge fund managers to manage risk, but you don’t have to be wealthy to access these programs. We also have carefully selected mutual fund portfolios that are designed to produce absolute returns. Minimum investments start as low as $15,000. Conclusions It is widely expected that the SEC will raise the accredited investor threshold from the current $1 million level (including your home) to $2.5 million (excluding your home) very soon. If so, you will have to have a net worth of at least $2.5 million to get the chance to look at privately offered hedge funds, futures funds, private equity funds, etc., which have recently become so popular. If you are an accredited investor under the current definition, but do not meet the $2.5 million proposed threshold, you may not have much time left to make a decision on investing in such privately offered investments that you may have been considering, before the door is shut. If the SEC raises the accredited investor requirement, this will only strengthen the belief among many non-accredited investors that the wealthy among us have an even more dramatic advantage when it comes to investing. But as I have pointed out in the paragraphs above, today it is possible for virtually any investor to enjoy the kinds of risk-managed investment strategies that were once primarily available only to wealthy investors. If you choose to do business with my company, we can introduce you to successful Investment Advisors that have proven systems and strategies with the potential to produce attractive returns with solid risk management along the way. Most of the Advisors I recommend also use hedge fund-like strategies. Most of these managers can be accessed for $25,000-$100,000 – far below the minimums required by many of the programs offered only to accredited investors. If you choose to invest with my company, we will also share with you the names of the carefully selected mutual funds that make up our Absolute Return Portfolios. You can access these mutual fund portfolios for as little as $15,000. As always, keep in mind that past results are no guarantee of future results, and not all of the programs I recommend are suitable for all investors. In closing, be aware that you don’t have to have a net worth of $1 million or $2.5 million to have access to many of the same or similar strategies that are used by hedge funds and other alternative investments. We can help you get these strategies into your portfolio. To get started, I encourage you to download my latest Special Report, and learn more about absolute return strategies and why they should be a part of your overall portfolio. Then call us at 800-348-3601 to get started. Wishing you profits,
Gary D. Halbert SPECIAL ARTICLES
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