Q&A: The Stock Market Sucks. Is Private Equity Any Better?

0:00Joe, have you ever changed your investment strategy based on the volatility of the market? No, not while the market was in super choppy waters. But what I have done is realized early in my investing career, the machine I built was not built as efficiently as I wanted it to be. And so I tweaked the machine, meaning I rewrote my investment policy statement. Ah, all right. Well, we're going to field a question from a caller who's worried about how choppy the waters are and is wondering if this maybe demands an overhaul of their investor policy statement. We're also going to talk to callers who have questions about growth assets versus income producing assets.

0:46We've got a caller with a comment about the efficient frontier. We've got a caller with a comment about following your passion. We got a lot of ground to cover today. All right. Welcome to the Afford Anything podcast, the show that understands you can afford anything but not everything. Every choice carries a trade-off. This show covers five pillars, financial psychology, increasing your income, investing, real estate, and entrepreneurship. It's double-eye fire. I'm your host, Paula Pant. I trained in economic reporting at Columbia, and every other episode, I answer questions from you with my buddy, the former financial planner, Joe Salcihai.

1:18What's up, Joe? Happy day, Paula. I got my coffee. We got questions. I have the amazing Paula Pant. What could be better? Absolutely. It's a wonderful day, and we will jump right in with this first question from Nick. Hi, Paula. My name is Nick and I'm from Dallas, Texas. My wife and I are 36 years old and we both have full-time jobs. We're currently making around$260 ,000 per year. Our monthly expenses are around$7 ,000 a month and we have about$550 ,000 invested, primarily in our 401ks, but we both also have Roth IRAs and brokerage accounts. We have around$200 ,000 in our emergency fund in our high yield savings account.

1:58And our only debt is our house at a 3.5 % mortgage with about 22 years left for payoff. So we have around$100 ,000 that we want to invest out of our emergency fund. And with current market volatility, we're looking for other investment options outside of equities. One idea we had was investing in the private equity market, such as Equities. on. My question is, what are some of the benefits, pitfalls, or blind spots of taking this strategy? Do we even have enough cash to even consider investing in private equity? We've looked at the real estate market, but feel that it's too much overhead for us with our full-time jobs.

2:32We're also open to other investment opportunities outside the stock market. Thank you so much for your consideration and time in answering my question. Nick, thank you for the question. My short answer is that while I'm a huge fan of private equity and of looking at investment options outside of the stock market, I worry that you might be going into the right thing for the wrong reasons. I question the premise a ton. Yeah. And by the way, Dallas, I just spent the weekend in Dallas. Nice place you live there, Nick. Loving Dallas, two and a half hours away from me. It's like Nick and I are neighbors here in Texas, Paula.

3:08Dallas is a fantastic city and it's growing so rapidly. So, so crazy rapidly. Yeah, I think that there is the devil that you know, which is the stock market. And he knows that the stock market, the U.S. stock market, we'll talk about that in a minute. But the U.S. stock market has been quite a devil lately, Paula. But the devil I think he doesn't know is that you are trading U.S. technology-based stock market risk for drama. Right. For tons and tons of drama and specific investment risk, which is a whole different world. Yeah, there's a lot of concentration risk with private equity. If you thought the volatility of public equities was bad, just wait until you see the volatility and lack of liquidity in private equity.

3:56And I don't want to sound like I'm bashing private equity. I actually, and I say this for the sake of everyone who's listening, totally support the right person going into private equity markets for the right reason. But it's got to be right person, right time, right reason. Private equity demands that you are an accredited investor, which means that you have over a million dollar net worth. Frankly, Paula, I don't like that. Yeah. And I'm sure you don't like it too. I can't stand that. It's a snobbish, crude. Approximation. Just absolutely boneheaded way of figuring out whether or not you are a sophisticated investor.

4:33I will long die on the hill that if they want some type of paternalistic test to see if you are a sophisticated investor, then give us a test. Paternalistic test. Yeah. If that's the approach, then fine. Give us a test similar to a driving test that you take at the end of driver's ed. Give us a test. Sure, fine, whatever. But to use whether or not you have a million dollars in assets or you have above a certain income level, to use that as a crude barometer for whether or not you are sophisticated enough to be an accredited investor, I think is absolutely horsewash. But that's the system that we have.

5:12And so that's the system that we live in. But Nick and everybody else, I'm sure, are wondering, Paula, why I brought that up. And the reason I brought it up is because I'm the guy that hates rules of thumb. But I think just like you've said in the past, rules of thumb point you toward the truth. I think this rule of thumb points toward a truth that you can very easily cover your financial independence goals using the things that are widely available to all of us. The stock market, real estate, those two asset classes very often over long periods of time are the two that consistently beat inflation.

5:52which is what we need to do. And the reason I bring that up is because when you're looking at private equity investments, what type of person should be evaluating that? I believe it's somebody that knows that on Maslow's hierarchy of needs, I very easily have enough set aside that even if this restaurant, office, technology company, healthcare, whatever it is, goes under, it's not going to wreck my investment world. And is it paternalistic? Yes. Is it silly? Yes. Is it way too broad and approximating? Absolutely. However, I think in this case, Nick, when you shared with us your net worth number and your age, while I applaud all of that, and I think you're doing a hell of a job saving, I don't think you have enough money to invest in private placements yet.

6:47I don't think you're there. Unfortunately, in order to be an accredited investor, you have to either have a net worth of over a million or have earned income of over 200 ,000 or earned income with your spouse jointly of over 300 ,000 in each of the last two years. He's like right on all those lines. Yeah, yeah, exactly. Or you need to have certain professional licenses like a Series 7, Series 65, or Series 82 license. You're not an accredited investor, even though I think that that's a complete baloney benchmark to have to hit. You're not yet an accredited investor. I think you quickly could be one if you wanted to be.

7:29So my concern for Nick is not whether or not he passes some stupid arbitrary qualification, because I think that he could if he wanted to. My bigger concern for Nick is, is he going into private equity for the right reasons? Because if the reason is a dislike of the volatility of the public equities market, I think that he's going to be leaving some volatility for more volatility. Yeah. When you look at a risk reward, a standard deviation chart, private equity is up, but it's up and to the right, meaning a lot more volatility and not soft volatility, right? Where we'll get a stock market that might go plus 20 or minus 20.

8:10No, no, no, no, no. We either 10X, 50X, or we go to zero. 100 % go to zero. And when we talk about volatility, what I want to point out is that volatility isn't a reason to run, especially if you're already there. It is a reason to look for opportunities. So whenever somebody tells me that the market's volatile and I want to get out, I do think you have to check your risk tolerance, Paula. and you have to see if, okay, can I handle that many stocks? But let's talk about this volatility too, because over on Stacking Benjamins, you were part of this discussion. It was, is it time to throw out international stocks?

8:53And we did that for a reason because I thought that it was ridiculous. The number of people in the personal finance universe saying, I don't need small cap. I don't need international. I'm just going to load up on the big stuff. Well, the big stuff now is through the floor. Right. Meanwhile, I just pulled up iShares and this was at the end of February. So I know this is dated a little, all right, but I just want to have some consistent data. Japan up 5.97. The Eurozone up 17.7. China large cap up 25.99. Broad China up 24. Broad-based Europe, 15%. Brazil up 16.7%, UK up 11.68%, South Korea up 13.6%.

9:38At the same time that everybody online is talking about, let's get rid of international. If you actually stayed invested, which is what people like you and me and my co-host over at Stacking Benjamins OG have been saying over and over and over, and frankly, it's a lot of what the Efficient Frontier helps you do, right? Just stay invested, you'd be high-fiving yourself right now because you probably have 20 % of your portfolio sitting in international funds that are saving your bacon. Yeah, exactly. I should say we're recording this end of March. So as of the time that we're recording this, the US stock market is in the trash can, but international is doing well.

10:22International is doing well. Yeah. I don't know how the stock market is going to be at the time that this episode airs. This is slated to air mid-April. But I do think, Paula, the delta between where the international markets are and the U.S. markets are, it's going to be a hell of a time for the U.S. market to bridge that gap between the time that we record this and the time that people hear it. Right. And what's cool about broad diversification is that if you're worried about volatility, broad diversification helps you reduce the volatility, which is, by the way, the reason why mutual funds were created in the first place.

10:57Because back in the 1940s, it was a way for small investors, like most of us, to realize what big investors knew for a long, long time, which is if I own several different things versus owning one, my chance of losing my goals, losing my ability to get where I want to go, goes through the floor. Which is also why JL Collins talks about just buy a little bit of everything when you start out, right? Own the economy. So Nick, the reason I'm questioning the premise myself, I won't speak for Paula, is because when you say, I want less volatility, volatility is a result of the market that you are in.

11:41If you go into private placement money during this same economy, if you're going into the US, Yes, you're in it, but in a much more first person, lack of diversification, lack of transparency, focused on one single management team. A much more concentrated bet. Very, very much more concentrated. Yeah. You are asking for so much drama. Yeah. Well, and the beauty of private equity is that when you can make a concentrated bet, you have the possibility of a huge concentrated win. Absolutely. That's why I'm an advocate for private equity for right person, right time, right reason. But we have to start with what's the goal?

12:27Is the goal to design a portfolio that has the possibility of a unicorn win? Or is the goal to reduce volatility in your portfolio? And Nick, based on the question that you asked, you said you're worried about the current market volatility of equities. So it sounds to me as though the goal is to reduce that exposure, that equity exposure that leads to volatility. And what that means to me is that you need more diversification and private equity would actually give you less diversification. If there was a way on a very small level for you to own a small amount, and by the way, I also question what I'm about to say, Paula, because the companies that are going to unicorn generally do not want the investor who's looking for a small amount.

13:12Right. By the way, I don't mean unicorn in the literal sense of it's going to reach a billion dollar market cap. Sure. Will it be a runaway winner? Absolutely. But companies that do that know what they've got. And they have the right management team. They have the right people. They're well-regarded. Companies that will let somebody invest the amount of money I'm talking about, maybe$10 ,000,$20 ,000,$30 ,000, though that's an even bigger risk. However, I do think that if you could do a small number like that in something that you like, I think you can begin learning from the school of hard knocks.

13:48Why is it important to know what the business plan is and not just talk to the CEO? I used to go through this all the time when clients would bring me private equity deals. They'd be like, oh yeah, listen to what they said. And I'm like, yeah, but none of that's on paper here. None of that is in the business plan. Oh no, but I talked to the guy. He's good. Like this guy's great. Well, just because he talks a great game doesn't mean that this new product to the market is going to have any wind beneath its wings, to quote Bette Midler. I can't believe it is quoted Bette Midler. Well, yeah, it's a lot of fun to go to AngelList or go to Hive and just spend some time poking around and seeing all of the companies that are out there.

14:29And if nothing else, it gives you a very good sense of the innovation that's happening and all the opportunity that exists. So those types of investments, especially if you can make a small bet, they're certainly fun. They're certainly educational, but they are a deep concentration of risk rather than a diversification away from risk. A hundred percent. I know that there used to be, and I don't have any names on me right now, but there used to be, Paula, some fintech companies that would pool together a bunch of smaller investors, and by smaller, I mean people that want to invest$10 ,000,$20 ,000,$30 ,000, smaller investors in that market.

15:12They pull them together and they go in as one market. And the people that run the FinTech operation actually have already applied their own filtering system on top of it. So they might be looking for investment in five different private placements. You get in to help them fill the barrel of money that they're looking for to come across together united as a single big investor, maybe going and looking for one of those companies. Now, the bad news when you do that, of course, what are you adding? You're adding another layer. Layer of management. Between you and the management team and higher fees, which by the way, the transaction costs sometimes on these private deals are not phenomenal.

15:53If you're used to 0.0007 and you get mad when you get 0.0009. Joe is exaggerating by a couple of decimal places. People's heads could explode. I'm going to pay 0.0009. Joe's exaggerating by at least two orders of magnitude, but your point is taken. The management fees, well, they're steep because there's a heck of a lot of diligence involved. Yeah. A lot of moving parts and people need to be paid. I mean, in this market, Paula, even France was up 15.78%. Even France, for goodness sakes. Don't get me wrong, France. I love you, but I'd never thought of you as an investment powerhouse. So Nick, I think that you're on the right track in asking the question, how can I diversify?

16:43But private equity per se is not for you a good road to diversification at this juncture. And besides which the paternalistic forces that determine accredited investors won't even allow it until you reach some certain arbitrary threshold anyway. That is so bad. Right? Daddy's not going to let you. Yeah, exactly. It's just so bad. Exactly. That's the system we live in. It drives me bonkers. But give us a driver's test. I will absolutely die on this hill. Give us a driver's test to test our level of sophistication. That would be a much better way of filtering. But no, no, that's not the system we have.

17:28They want you to get a raise at work and then you're an accredited investor. So thank you, Nick, for the question. Hey, Paula, before we move on, I'm looking at all these iShares, right? Yeah. Which country of all the countries represented in BlackRock's iShares Exchange Traded Funds was up the most at the end of February year to date. Which country? And not the US. Not the US. Well, US is down, right? Okay. Which country up the most? Let me think about, well, China is the obvious answer. So I'm not going to guess China because it's too obvious. China looking good though. We were talking about that in the mid-20s.

18:08I mean, that's some good cha-ching already for one quarter or, well, one sixth of the year. Yeah, but too obvious, so I'm not going to guess it. Bangladesh is under an interim government right now. They're still cleaning up after their treasury got robbed. So I'm not going to guess them. And I'm also not going to guess India. So I'm methodically eliminating South Asia. This is an Eastern European country. I know. Is it Latvia? Right next door. Lithuania? No, no, no. Come south. Estonia? Wait. Poland. Poland. Poland. Can you believe it? Poland, number one in the world. Congratulations. Go Poland.

18:50At the end of February, up 37.72%. Wow. Percent. That's wonderful. Congratulations to Poland. It's amazing. Yeah. Anyway, that blew me away when I saw it. Amazing. Speaking of amazing, we've got another caller coming, Paula. We do. Cindy is 10 years away from being work optional, possibly even closer, and is wondering how to split her investments. Meanwhile, Josh has some questions about Roth versus trad when it comes to retirement withdrawals. And we got a couple of comments, one on the efficient frontier and one on following your passion. All of that is coming up next. The kids are back in school now, and I finally have some extra time to plan a weekend getaway for just us.

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22:23Welcome back. Our next call comes from Cindy. Hi, Paula. This is Cindy. I have a question about building out a taxable account with income yielding assets versus an account with growth assets. So a little bit about my financial situation. Between me and my husband, we have over$900 ,000 saved. We are in our mid 40s. We have no debt. and 90 % of that money is in retirement accounts. So my focus now is going to be building out my taxable account. And we have a goal of being work optional in 10 years. And I've read different things about investing in growth and then converting it when I'm ready to retire to income yielding assets or doing that now and reinvesting.

23:21And I know there's tax consequences associated with that. And I wanted to get your thoughts on that. Cindy, thank you for the question. So first, if you're talking about investable assets, so if you're talking about sticking in the equities market, then broadly speaking, optimizing for growth in the value of the underlying asset is a better long-term approach than optimizing for high dividend stocks. So if you're thinking about, for example, pursuing a strategy of having a huge portion of your portfolio in a bunch of high dividend yielding funds, I think a portion of that is fine, but I wouldn't put too much of your portfolio into chasing high dividend funds.

24:05I would instead allocate your portfolio towards companies that you think will grow. Now, I want to clarify that when I say growth, I don't mean growth as in growth versus value funds in terms of investment style. When I say growth, what I'm referring to is that any asset earns money in two ways. There's the appreciation of the asset itself, and then there's the dividend that it pays or income stream that it pays. And so when I say growth, I don't mean growth versus value as a style. I mean, assets that are likely to appreciate in value, equities that are likely to rise in value over time. I would focus on that as a long-term strategy for the bulk of your portfolio, as opposed to choosing specifically a whole bunch of high-dividend stocks.

24:53The difficulty, Paula, in that approach is that what you do when you go with growth-oriented stocks is you increase. My favorite measurement of risk, I mean, they all do something a little different, but the one that I always look at first is standard deviation. That's the amount that it's going to fluctuate. And so you're going to be on a much more volatile train, which is going to make it more important than ever that you don't miss when you're pulling money out to spend it. Because high volatility means, like we were just talking about with Nick, high up, but also potentially high down. And when things go down and that sequence of returns works against you, it's going to work against you more if it's a position that doesn't pay dividends than one that does.

25:41And by the way, for people that don't know why that is, so why do dividends mean a higher standard deviation? Like, Joe, how can you say that? How do you know that? Well, the reason is that companies pay dividends. They return money to shareholders when truly their growth options with that money, there really aren't many. A railroad isn't going to be doing a lot of expanding lately, last hundred years across the plains anymore. So instead, the money that they make, they return it to shareholders. So a company that's big, established, not much room for growth, they're going to pay a dividend. A high dividend.

26:20Yeah. Yeah. And a company that doesn't pay a dividend, they don't pay it because the owner and the management team knows that money is better left with the management of that company. Right. It's better off reinvested. Exactly. And so for long-term investments, you want the types of companies where there is that room for growth, where the management is reinvesting back into the growth of the company because there's room for expansion. Those are the staples that you want in your portfolio when you're taking a multi-decade approach. Whereas when you're actually in the withdrawal phase, moving more of your money into high dividend assets at that time makes a lot more sense.

26:59I think though, Paula, when you're moving into the retirement phase, I think there is some room for both, not either or. Oh yeah, absolutely. Where you know that you're going to get hit a little harder with taxes, but we're still looking for some growth. So an investment like the Spider S &P dividend ETF, as an example, that'll kick out a 2.5 % dividend versus a 1 % dividend. So more of that money is in your pocket. The companies are a little bigger, but they're still got some companies in there that are looking to grow. So you're going to get some of the growth, a higher dividend, you're going to pay marginally higher taxes, but you're not turning on this tax me to hell engine.

27:41By doing that, I think there's some midpoints there that you can explore. And what I like most about that, Paula, you're also decreasing the standard deviation. Looking at standard deviation as an example, I'm looking at this S &P dividend ETF, ticker symbol SDY right now. Standard deviation over the last three years, 16 and a quarter versus the S &P 500 growth index 19 and a quarter. Now you hear 19 and a quarter and 16 and a quarter, that doesn't sound like a huge difference, but think about three points in 16. I mean, that's a big difference in volatility. That is a nice difference. Again, it doesn't mean that it can't go down to standard deviation to 16 points either way from your average 66 % of the time.