There are an infinite number of ways to build a portfolio, and any financial advisor will tell you the key inputs in determining how to structure your portfolio are your time frame and risk tolerance. That’s solid advice. However, like most things in life, the reality is slightly more complicated than it first appears.
It’s easy enough these days to go to a robo-advisor, sign up and let its algorithms spit out your ideal, globally diversified, low-cost portfolio that meets your objectives and risk tolerance parameters. That’s a good approach, and I have a decent portion of my portfolio invested exactly this way. My goal for the capital in this portion of my portfolio is simply to match whatever the major indices do and not pay too much in fees. These investments will compound over time, and in 10, 20 or 30 years, I should see that my capital has grown by an average of roughly 6% annually. It’s certainly not sexy, but remember that compounding is the single most powerful force in finance.
What has always bothered me, though, is that compounding doesn’t just apply to public equity investments. Why is it that major endowment funds — like Yale’s endowment fund, one of the largest at $31.2 billion assets under management and which generated returns of 12.4% annually over the past 30 years through June 2020 — have so much of their investments held in alternative assets? What do they know that other investors don’t?
As it turns out, Yale has known something for years that the rest of us are just now legally — thanks to the JOBS Act and the rise of crowdfunding platforms — catching up on. Since the object of investing is to increase returns while decreasing risk, the attractiveness of alternative assets becomes clear. Alternative assets are generally uncorrelated with public markets, so by investing in a range of asset classes beyond traditional stocks and bonds, you can construct a portfolio that has the potential to generate higher returns at lower risk.
Circling back to the robo-advisor example, my well-diversified portfolio wasn’t actually that well diversified at all. Perhaps it was in stocks and bonds, but certainly not among asset classes, which is a crucial point of omission. So, I decided to augment my portfolio with alternative assets and, in particular, venture capital (VC)-style investments.
Why VC-style investments? It’s simply because they offer the potential for bigger upside. And unlike the entrepreneurs you are investing in, you can build a diversified portfolio within the asset class to give yourself a better chance of success.
In the 1980s and ’90s, most value creation happened for investors in the public market who bought stocks after their initial public offering (IPO). Now, early stage private company investors benefit from most of the value creation. Cisco went public in 1990 with a market cap of $220 million, to the benefit of its founders, employees and investors. As of this writing, Cisco’s market cap sits at roughly $206 billion. Private, pre-IPO investors and post-IPO stock purchasers both had immense opportunities to realize value on their investments. The same holds true for Amgen, whose IPO raised $40 million and which is valued at $133 billion.
Nowadays, companies wait much longer, are more mature at the time of their public offering and can go public at much higher market capitalizations. In 2020, 88 companies raised more than half a billion dollars in their IPO and a record-breaking 28 raised over $1 billion. This is a boon to their private investors but means there’s less value to be realized post-IPO. One way to take advantage of this is to become an angel investor and invest in businesses that show promise.
Clearly individual investors have a very different risk profile than large institutional investors, so the amount an individual allocates to higher-risk private investments will be drastically lower compared to the Yales of the world (for example, less than 10% for individuals compared to almost 50% for Yale). Private investments are also illiquid, so it's important only to invest patient capital, or capital with a long-term time horizon that you won't need to access to fund your lifestyle, for example, to buy a home. Furthermore, power laws are at play when investing in the VC asset class, meaning that out of a portfolio of, say, 10 companies, multiple companies will fail, while several may return some portion of your capital, and one or two will account for the majority of your returns. This is why building a diversified portfolio within the asset class is critical to long-term success.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
This article was originally published to Forbes on March 29, 2021. Forbes Finance Council is an invitation-only organization for executives in successful accounting, financial planning and wealth management firms.