Beware of Shark Tank Investing: Private Companies Are Too Risky

SEPTEMBER 18, 2014
Benjamin Sullivan
For a billionaire like Mark Cuban, a regular on the TV show Shark Tank, investing in a private company is okay.  But not for almost everyone else.  Stick to a diversified portfolio of public investments.

When Cuban gives a company $1 million, that’s less than 0.05% of his net worth. Someone worth $1 million would have to invest less than $500 to make a proportional investment.

Clients sometimes ask me to vet an opportunity to invest in a private company. I usually find too many red flags. Some common problems are: no track record, unrealistic projections, no business plan, or large downside risk accompanied by limited upside. In these cases, I advise the client to not invest. Sometimes, a small investment is okay, but concentrating too much in one company creates unnecessary risks. 

People feel that public markets might be overvalued since they’ve seen prices almost triple since the 2009 lows. In contrast, people see private companies as less risky. But you can’t talk about risk without examining the price.

It’s easy to forget about the price when you’re buying a company that’s not traded on a stock market.  That’s a mistake. You must understand the price you’re paying. But without extensive research, it’s impossible to say whether the price is fair or far too high.

Another disadvantage is that small companies often have multiple rounds of investment. 

If you’re not willing to make follow-on investments, your interest might get diluted.

Nonetheless, investing in private companies can be appealing because of the personal connection. Just because you know someone, it doesn’t necessarily mean that individual will be a capable entrepreneur.  It’s never a sure thing that even a promising company will succeed.  There are a million and one variables. The risk is rarely worth the potential reward.

Excitement without Gambling
Investments like Exchange Traded Funds (ETFs) and mutual funds seem boring in contrast. But investors can get excited about sensible investing if they think about it the right way.

When you buy an S&P 500 index fund, you invest in great companies like Apple, Exxon and Procter & Gamble. For instance, those 3 companies make up 7% of the index.  Each of these companies — and many others in the S&P 500 — has a compelling investment story.
Investing in an index fund won’t give you a rush of adrenaline like seeing your stock going up 10% in a day, but, ultimately, it’s more exciting to see your portfolio double and triple in value over the years.

If investors aren’t willing to buy the market as a whole, actively managed funds can allow a professional manager to try to increase returns by picking companies that are undervalued. Actively managed funds are less risky than stock picking or private-company investing and can make sense in the right proportions and right markets. Index equity funds are bedrock investments, but actively managed funds can play a key role too once you have a reasonable amount of money to invest. 

I recommend putting about 60% of your equity investments in index funds. Use them to invest in large companies in established markets like the United States, Japan and Europe.
Place about 40% in actively managed funds that invest in small-cap stocks, emerging markets and specialty areas such as Real Estate Investment Trusts (REITs). In these less heavily researched and less efficient markets, a skilled manager can earn the management fee. But don’t invest in any fund that has excessive fees.

With private companies, if you’re lucky, you may hit a home run, but far more often, you’re going to strike out. Hitting singles and doubles consistently with funds is the time-tested way to build long-term wealth.

Benjamin Sullivan, Certified Financial Planner (CFP®), EA, works in Palisades Hudson’s Scarsdale, NY, headquarters.

Palisades Hudson (www.palisadeshudson.com) is a fee-only financial planning firm and investment advisor with more than $1.3 billion under management. It offers investment management, estate planning, insurance consulting, retirement planning, cross-border planning, business valuation and appraisal, family-office and business management, tax preparation, and executive financial planning. Branch offices are in Atlanta, Fort Lauderdale, Fla., and Portland, Oregon. Read the firm’s daily column on personal finance, economics and other topics at http://palisadeshudson.com/current-commentary. Twitter: @palisadeshudson. 



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