by Scott Ronalds
“I’m thinking of taking some money out of my portfolio with you guys to buy some shares in a blockchain-related start-up. Am I crazy?”
We were asked a question along these lines recently, and I suspect we’ll hear it again, whether it’s blockchain, bitcoin, cannabis, space tourism or whatever new investment opportunity seems exciting. Our answer might surprise you.
No, you’re not crazy. We don’t necessarily think it’s a bad thing to invest a portion of your portfolio in an unconventional, illiquid, or even highly speculative investment. You can learn a lot from it. We do have a few caveats, however. Most importantly, you need to have a high tolerance for risk and should be mentally prepared to lose everything you invest, because you just might. Below are a few other things to consider.
Limit it to 5% of your portfolio
Five percent isn’t a magic number, but curbing a risky investment to 5% or less of your total portfolio will limit the damage if things go south. True, it will also limit your potential upside, but it’s a prudent trade-off. You don’t want to put your retirement plans and future standard of living at risk by investing too much of your portfolio in an adventure.
Have a plan
This seems obvious, but we find it’s often overlooked. Let’s use bitcoin as an example. Say you invest in the cryptocurrency when it’s value is $16,000. What will you do if it falls to $8,000? Or if it rises to $24,000? Do you have a floor and ceiling in mind for how much you’d be willing to lose or gain before making a difficult decision with your investment? Bitcoin is a great example of the hyper volatility that comes with speculative investments. You need to be prepared for it, and you need to have a plan.
Consider how it will change the risk profile of your portfolio
If your target breakdown between stocks and bonds is 60/40 and you want to carve off 5% to invest in a start-up, for example, you should be taking the money from the stock portion of your portfolio so that you don’t inadvertently increase your overall level of risk. If you’re venturing into investments that are higher up the risk spectrum, you shouldn’t fund them by cashing in your safer stuff (e.g. cash and bonds).
Further, if you hit the jackpot on a speculative investment, it will comprise a larger portion of your portfolio, which means you should think about reducing the level of risk in the rest of your accounts to keep your overall balance between growth and safety in check. On the other hand, if your investment tanks, your overall portfolio may have less exposure to growth assets than your plan calls for. In this case, it would be appropriate to increase your exposure to stocks. After a bad experience with a high-risk investment, this can be hard to do.
Read the fine print on fees and redemption clauses
If it’s a product or offering that you’re considering, rather than an individual security, be sure to do your homework on fees. They’re often egregious on things like closed-end funds and specialty funds. And if you’re buying an illiquid investment or thinly-traded security on your own, be cognizant that there are brokers/traders on the other end that probably have much more experience than you and don’t have your best interests in mind.
Also, be sure to ask about any clauses or conditions that may lock you into an investment for a specific period. If you want to get out, you don’t want to be told you can’t. Further, illiquid investments can be difficult to sell, as with any transaction, there needs to be a willing buyer.
A final word on speculative investments: while they can be profitable, they can also be very complex, and it goes without saying, volatile. In our experience and discussions with clients, the biggest thing many investors learn is that they weren’t prepared for the wild ride when their own money was on the line.
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