Here's How The Rich Invest Their Money

Summary

This video script explores how wealthy individuals differ from the average investor, focusing on alternative investments like private equity, real estate, and hedge funds. It discusses the risks and complexities associated with these assets and challenges the idea of blindly copying the investment strategies of the rich. The speaker advocates for a simple, globally diversified, low-cost portfolio for most investors, suggesting that alternative investments are often overcomplicated and not as advantageous as they seem.

Takeaways

• 🤔 Wealthy individuals often have different investment strategies compared to the average investor, focusing on alternative investments rather than just stocks, bonds, and cash.
• 💼 The average investor's portfolio typically consists of 65% stocks, 25% bonds, and 10% cash, according to a Vanguard report on American investors.
• 🏦 Ultra high net worth individuals allocate significantly less to traditional assets like stocks and bonds, with a larger portion in alternative investments such as private equity, real estate, and hedge funds.
• 💡 Portfolio construction theory suggests that diversifying investments with less correlated assets can reduce risk and potentially enhance returns.
• 🏠 Wealthy people tend to diversify beyond their homes, which are often considered high-risk due to the concentration of wealth in a single, often leveraged, asset.
• 📈 Real estate investment trusts (REITs) offer retail investors a liquid and accessible way to invest in a diversified property portfolio.
• 🌐 Commodities are generally not favored by the wealthy for investment due to their lack of income production and management.
• 💼 Private equity involves investing in private businesses and can offer higher expected returns due to the risks and illiquidity associated with these investments.
• 💡 The success of private equity investments often depends on the investor's network, expertise, and ability to add value to the businesses they invest in.
• 💸 High fees are common in private equity funds, with a study indicating an average fee equivalent to 6% per year.
• 📊 Hedge funds offer a wide variety of investment strategies and often come with high fees, but their performance can be unpredictable and is not always superior to traditional investments.

Q & A

Why do wealthy individuals often invest differently from the average investor?

Wealthy individuals often invest differently because they have access to alternative investments that were traditionally only available to large investors. They also tend to have more capital, expertise, and a different risk tolerance, allowing them to diversify beyond traditional assets like stocks, bonds, and cash.

What are the three main building blocks of an average investment portfolio?

The three main building blocks of an average investment portfolio are stocks, bonds, and cash.

According to the Vanguard report, what is the typical allocation of an average investor's portfolio?

The typical allocation of an average investor's portfolio is 65% stocks, 25% bonds, and 10% cash, although this allocation may vary depending on the investor's age.

What is the primary reason that wealthy people allocate a significant portion of their investments to alternative assets?

Wealthy people allocate a significant portion to alternative assets because these assets can potentially reduce risk and enhance returns by being less correlated with traditional asset classes, thus providing a smoother investment journey.

Why do wealthy investors tend to invest less in real estate compared to the average investor?

Wealthy investors tend to invest less in real estate because they aim to diversify beyond their homes into other asset classes. They also recognize that having a large portion of wealth tied up in a single, often leveraged, property can be risky and less liquid.

What is the general expectation for returns from private equity investments according to the script?

Private equity investments are expected to have higher returns than public companies due to their higher risk nature, smaller size, and illiquidity. However, the reality is that most businesses can be poor investments, with venture capital funds expecting a significant portion of their investments to fail.

Why might it be dangerous to blindly copy the investments of wealthy individuals?

Blindly copying the investments of wealthy individuals can be dangerous because each investor has different goals, risk tolerances, and portfolio compositions. Without understanding the context of their investments, one might end up with an unsuitable strategy that does not align with their own financial objectives.

What are some of the challenges associated with investing in private businesses directly?

Challenges with investing in private businesses directly include the need for domain expertise, a significant amount of capital for diversification, and the illiquid nature of such investments. Additionally, there is a high risk of losing the entire investment.

What is the typical fee structure for private equity funds, and why are they considered high risk?

Private equity funds typically charge high fees, with an average equivalent to 6% per year according to a 2020 study. They are considered high risk due to their illiquid nature, high fees, and the unpredictable returns that come with investing in private businesses.

Why do hedge funds often charge high fees, and what is the potential downside for investors?

Hedge funds often charge high fees, including a 2% annual fee plus a 20% performance fee. The potential downside for investors is that they may end up losing a significant portion of their returns to performance fees, especially if they invest in multiple funds with varying performance.

What is the author's opinion on the best investment strategy for most retail investors?

The author believes that a simple, globally diversified, low-cost stock and bond portfolio should be sufficient for most retail investors, providing 95% of the desired investment outcome. The author suggests that alternative investments are best ignored by retail investors due to their high risk, high fees, and complexity.

Outlines

00:00

🤔 Wealthy Investment Strategies and Public Access

The paragraph discusses the common dilemma faced by an average investor when it comes to managing wealth and the complexity of investment options beyond traditional stocks and bonds. It highlights the shift in investment opportunities for retail investors, who now have access to the same wealth management tools as the rich, such as alternative investments like private equity and hedge funds. The speaker, with 12 years of experience in wealth management, aims to explore why wealthy individuals invest differently and whether average investors should follow suit. The paragraph sets the stage for a deeper dive into the investment strategies of the ultra-wealthy, contrasting the traditional stock-bond-cash portfolio of the average investor with the diversified and less conventional approaches of high-net-worth individuals.

05:01

🏘️ Diversification Beyond Real Estate

This paragraph delves into the common misconception of considering one's primary residence as an investment and the risks associated with having a significant portion of one's wealth tied up in a single property. It contrasts the typical investor's heavy allocation to their homes with the wealthy's strategy of diversifying beyond real estate into other asset classes. The speaker discusses the benefits and challenges of direct commercial property investment, the liquidity issues with property funds, and the advantages of real estate investment trusts (REITs) for retail investors. The paragraph emphasizes the importance of diversification and the personal decision-making process when considering real estate as part of an investment portfolio.

10:02

💼 Private Equity and High-Risk Investments

The focus of this paragraph is on private equity, which involves investments in non-publicly traded companies. It explains the appeal of private companies for wealthy investors, the potential for higher returns due to higher risks, and the illusion of reduced risk due to infrequent valuations. The speaker outlines the categories of private equity funds, including venture capital and buyout funds, and the high rate of failure expected in venture capital investments. The paragraph also touches on the unique perspective and comfort with risk that wealthy individuals have, stemming from their experience in starting businesses and their ability to take on higher risk due to their financial security.

15:03

📊 The Risks and Realities of Alternative Investments

This paragraph addresses the complexities and high fees associated with alternative investments, such as private equity and hedge funds. It discusses the challenges of identifying and accessing high-performing funds, the unpredictability of returns, and the potential for significant losses. The speaker also mentions government incentives that make investing in private companies more attractive for retail investors in the UK. The paragraph concludes with a cautionary note on the importance of understanding the specific risks and rewards of alternative investments and the need for a well-thought-out strategy rather than blindly copying the investment strategies of others.

🧐 The Paradox of Wealthy Investment Behavior

The final paragraph challenges the notion that wealthy individuals' investment choices are always rational or superior. It suggests that the complex and high-fee investment strategies often pursued by the wealthy may not be the most effective for the average investor. The speaker argues for the benefits of a simple, globally diversified, low-cost stock and bond portfolio as the foundation for most investors, with alternative investments being a secondary consideration. The paragraph emphasizes the importance of simplicity and cost-effectiveness in investment strategies and warns against the allure of complex solutions that may not necessarily yield better results.

Keywords

💡Wealth Management

Wealth management refers to the professional guidance and services provided to individuals with substantial financial resources to grow, protect, and manage their assets. In the video script, it is mentioned that the speaker has worked in wealth management for 12 years, emphasizing the expertise required to understand the different ways wealthy people invest their money compared to the average investor.

💡Asset Allocation

Asset allocation is the process of dividing investments among different asset classes, such as stocks, bonds, and cash, to optimize returns and manage risk. The script discusses how the average investor and the ultra-high net worth individuals differ in their asset allocation strategies, with the latter often investing in alternative assets.

💡Alternative Investments

Alternative investments encompass a wide range of non-traditional investment vehicles, including commodities, real estate, hedge funds, and private equity. The script highlights that wealthy individuals often allocate a significant portion of their portfolio to these assets, which are typically less accessible and more complex than traditional investments.

💡Public Stocks

Public stocks refer to shares of companies that are publicly traded on stock exchanges and available for investment by the general public. The script notes that ultra-high net worth individuals allocate a smaller percentage of their portfolio to public stocks compared to the average investor.

💡Private Equity

Private equity involves investing in privately held companies, which are not publicly traded on stock exchanges. The script explains that wealthy individuals often have a large allocation to private equity, seeking higher returns for taking on additional risk and illiquidity.

💡Real Estate Investment Trusts (REITs)

REITs are companies that own, operate, or finance income-producing real estate and are traded on stock exchanges, allowing investors to gain exposure to real estate without directly owning properties. The script discusses the benefits of REITs in terms of liquidity and diversification, contrasting them with direct real estate investments.

💡Commodities

Commodities are basic goods that are interchangeable with other goods of the same type and are often used as primary inputs in the production of other goods or services. The script mentions that commodities do not produce income and are less favored by wealthy investors compared to productive assets like businesses.

💡Hedge Funds

Hedge funds are a type of alternative investment vehicle that pools capital from accredited investors and uses a variety of strategies to earn active returns. The script points out the high fees associated with hedge funds and their potential to diversify a portfolio, but also notes the challenges in assessing their performance.

💡Portfolio Construction

Portfolio construction is the process of building a collection of investments to achieve a desired balance of risk and return. The script refers to portfolio construction theory to explain why adding less correlated assets, such as alternative investments, can reduce overall portfolio risk.

💡Illiquidity

Illiquidity refers to the difficulty of converting an investment into cash without a significant loss in price. The script discusses the illiquid nature of private equity investments and how wealthy investors can afford to tie up their money for longer periods in pursuit of higher returns.

💡Risk Tolerance

Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand. The script emphasizes that wealthy individuals often have a higher risk tolerance due to their financial security, allowing them to invest in riskier assets for potentially greater returns.

💡Performance Fees

Performance fees are fees charged by investment managers, typically a percentage of the profits, as a reward for achieving positive returns. The script notes that hedge funds often charge performance fees, which can significantly reduce investor returns, especially when considering the overall performance of the funds.

Highlights

Wealthy individuals tend to invest differently from the average investor, often focusing on alternative investments.

Small investors are increasingly able to access the same investment tools as the wealthy due to new platforms and funds.

The average investor's portfolio typically consists of 65% stocks, 25% bonds, and 10% cash, according to a Vanguard report.

Ultra high net worth families allocate significantly less to traditional assets, with a larger portion in alternative investments.

Alternative investments include private equity, real estate, hedge funds, and other assets that can reduce portfolio risk.

Portfolio construction theory suggests that adding less correlated assets can reduce risk and enhance returns.

Wealthy investors often diversify beyond their homes into other asset classes for better risk management.

Real estate investment trusts (REITs) offer retail investors a liquid and diversified way to invest in property.

Commodities are less favored by wealthy investors due to their lack of income production and management.

Private equity investments in private businesses can offer higher expected returns but come with higher risks.

Wealthy investors often have the network and expertise to manage the risks associated with private equity.

Private equity funds are high risk, illiquid, and can have high fees, yet they have historically outperformed public markets.

Hedge funds offer diversification and potential for absolute returns but often come with high fees.

The performance of hedge funds can be variable, with significant dispersion in outcomes.

Past performance in private equity and hedge funds is not a reliable indicator of future results.

The government in the UK offers tax incentives for retail investors to invest in small innovative businesses.

Wealthy investors may be drawn to complex investment solutions due to their background and desire for exclusive opportunities.

Simple, globally diversified, low-cost stock and bond portfolios are often the most effective for long-term investing.

Transcripts

a few weeks ago I was chatting with a

prospective new client and he said James

I spend a lot more of my time than I

would like thinking about my money and

whether it's invested correctly because

I find myself going around in circles

there's just so much information out

there and so many options to choose from

I understand the basics you know your

stocks and your bonds but what confuses

me is all these other things that you

can invest in Commodities real estate

investment trusts Alternatives like

hedge funds and private Equity you never

really talk about these things in your

videos but from the reading that I've

done it seems that rich people tend to

invest heavily in these things and given

that they're so rich they must know what

they're doing right so my current train

of thought is why don't I just copy them

this is a really good question I have

worked in wealth management for 12 years

and I can tell you that really wealthy

people people with tens or hundreds of

millions tend to invest their money in a

completely different way to the average

investor so what is it that these

wealthy people know that everyone else

doesn't

and why aren't more people copying them

well in the past the main reason was

that small investors were not able to

access these types of Investments they

were only available to large investors

but now that is starting to change and

there are platforms and funds that allow

retail investors to access many of the

tools that wealthy people use so now for

the first time there is the ability for

people like you to copy how the

wealthiest invest their money but the

question that we're going to answer

today is should you the first thing that

we need to understand is what are

wealthy people investing in and how does

that differ from the average investor

when thinking about building an

Investment Portfolio there are three

main building blocks you have stocks

bonds and cash for the average investor

it's likely that their Investment

Portfolio will consist of some

combination of these three in 2020

Vanguard produced a report on the five

million Americans that use their

platform which showed that the average

investor has a portfolio of 65% stocks

25% bonds and 10% cash although this did

vary greatly depending on their age

starting off with higher allocations to

stocks when they're younger and then

declining as they get older as you might

expect the median account balance was

$60,000 so I think this is a pretty good

proxy for what the average Investor's

portfolio looks like but how then do the

wealthiest invest their money each year

JP Morgan surveys ultra high net wealth

families from across the world to

understand how they invest their money

and they found that on average they

allocate 8% to cash 12% to bonds and 26%

to public stocks so they have less than

half of their money invested in these

traditional asset classes that normal

investors use a tiny amount in

Commodities and infrastructure but the

largest allocation by far is two

alternative Investments breaking that

down they have 177% in private Equity

15% in real estate 5% in hedge funds 5%

in V capital and 4% in private credit

and it's not just wealthy individuals

that invest in these types of things us

endowment funds some of the largest

pools of capital in the world typically

have high allocations to these

alternative asset classes so the

question is why are they doing this

these are some of the wealthiest people

on the planet who have access to the

best investment advisors so what do they

know that other people don't we're going

to take a look at each of these asset

classes to understand why these people

are using them and whether you should be

too but to understand why they're doing

this we first need to go back to

portfolio construction Theory 101

investing is not just about trying to

get the best possible return it's about

trying to deliver the best possible

return for a given level of risk over

the long term stocks tend to deliver

higher returns than bonds but stocks can

be extremely volatile with a diversified

portfolio you might expect that at least

once a year it might fall by 10% every 5

years it could fall 30% and once in a

generation by 50% if not more now not

everyone can stomach a roller coaster

like that so if you're looking for a

smoother less painful investing journey

in theory you can blend stocks and bonds

together to build a portfolio that

you're more comfortable with but this is

the thing although the return for this

50/50 portfolio would be the sum of its

parts because stocks and bonds are not

perfectly correlated with each other the

volatility of the portfolio would be

less than the sum of its components and

in theory if you continue to add other

less correlated assets into your

portfolio it can reduce the risk even

further which means that you can now

actually achieve a much higher return

for the level of risk that you're

willing to take this is why adding

alternative asset classes to your

portfolio can help to reduce risk and

enhance returns in theory but do they

actually do what they say on the tin and

if so should you be using them let's

start with real estate this is the odd

one out because it's the only one where

the wealthier people get the less of it

they tend to own and this is because the

average investor typically has between

50 and 90% of their wealth tied up in

their homes I don't think you should

think of your home as an investment but

most people do and from that perspective

having the vast majority of your wealth

tied up in a single often highly

leveraged house on a single Street in a

single city is actually a pretty

high-risk position to be in the reason

people tend not to recognize this is

that you can't see the value of your

home fluctuating on a daily basis like

you can with stocks it also means that

you're sitting on a lot of capital that

could be working for you elsewhere so

one of the first things that wealthy

people do is to diversify beyond their

homes into other asset classes even

within this 14% property allocation

there will be a lot of diversification

some of this will be homes but there's

also going to be Direct commercial

property and property funds the

challenge with directly investing into

commercial property is that it requires

domain expertise a lot of capital if you

want to be Diversified and it's a liquid

wealthy people obviously have access to

a lot of capital expertise and liquidity

tends not to be a problem because they

also tend to have a lot of other money

invested into highly liquid stocks and

bonds which means that they can afford

to tie up other parts of their portfolio

for the long term these are all things

that the average investor tends not to

have property funds however can give you

instant diversification by allowing you

to own a small slice of a property

portfolio however as we see from time to

time in the news these funds often have

their own liquidity ISS isues meaning

that you may not be able to get your

money out when you need it real estate

investment trusts offer a solution to

this because they are close-ended funds

that are listed on a stock exchange

making them highly liquid and an

accessible way for retail investors to

get access to a diversified property

portfolio but should you it's a personal

decision but firstly if you do it's

really important that you pick a good

fund which is always hard to do in

advance and secondly if if you already

have so much money tied up in your home

does it really make sense to invest in

even more property when you can get

better diversification elsewhere the

other thing that wealthy people tend not

to invest in is Commodities mainly

because a lump of gold will always be a

lump of gold it does not produce an

income and there is no management team

trying to turn it into two lumps of gold

although arguably Commodities can be

useful for inflation protection wealthy

people prefer to get that protection via

investing in productive assets like

businesses

and for downside protection they prefer

to use things like hedge funds but

before we get into them let's first talk

about private Equity these are Holdings

in private businesses that do not trade

on a stock exchange businesses like

SpaceX revolute or anything down to just

a small chain of dry cleaners in theory

private companies should have higher

expected returns than public companies

because they tend to be smaller have a

higher chance of failure and are IL

liquid they are very hard to sell and

investors should demand higher returns

for these additional risks however

unlike with public companies there is no

index that you can invest in that will

give you exposure to all private

companies and capture the average return

of the sector instead you have to invest

directly into individual companies

yourself or through actively managed

private Equity Funds of which there are

two main categories Venture Capital

which focuses on small early stage

companies and buy out private Equity

Funds that invest in larger more

established businesses

one of the reasons people like private

Equity is that just like the value of

your home because this stuff is not

valued on a regular basis it can give

off the illusion that it's a lot less

risky than it actually is but the

reality is that most businesses make

terrible investments in general Venture

Capital funds expect six out of 10 of

the companies that they invest in to go

bust within the first 5 years so a

complete loss of capital they expect

three out of 10 to survive and when they

are finally able to sell their shares

which might not be for five or 10 years

they hope to break even and they expect

just one out of 10 to actually come good

and hopefully deliver a return that

makes up for all the other losses when

it comes to investing directly into

private businesses there is a high

chance that you could lose all of your

money to understand why wealthy people

are often comfortable with these risks

we need to zoom out and think about who

they are firstly the vast majority of

wealthy people did not make their money

by investing in a Diversified way most

of them made their money by starting

businesses so these are people who are

often not only very comfortable with

those risks but they then have a network

of connections to help find

Opportunities to invest and they have a

skill set to not only vet those

businesses but in many cases add value

to them wealthy people can also afford

to take much higher risk than the

average person for example imagine if

you were in a position where you could

say with confidence that you only need

50% of your Investments to sustain your

family's quality of life moving forward

you'd probably invest that 50% in

traditional lower risk highly liquid

assets which means that you're then free

to take a lot of risk with the rest of

your portfolio and tied up for the long

term in the pursuit of higher returns

this is one of the reasons why it is so

dangerous to blindly copy the

Investments of other people whether this

is someone that you found on YouTube a

famous investor like Michael bur or just

a mate in the pub before copying them

not only do you need to understand why

they are making that specific investment

but more importantly how it fits in with

the rest of their portfolio and how they

think it is going to help them achieve

their specific goals because the chances

are that either they have not thought

about it properly themselves or your

goals and objectives will be very

different to theirs and if you copy them

you might end up using a sledgehammer to

knock in a nail these are the reasons

why directly investing into private

companies is not suitable for the vast

majority of people but what about

private Equity Funds where you have a

management team that will do all of this

for you in the past these funds have

only been available to wealthy investors

and institutions that are looking to

invest large amounts because think about

it if you're a fund manager trying to

raise money for your fund would you

rather take that money from a small

group of knowledgeable investors or

thousands of retail investors who are

going to ask a lot of basic questions

and create a lot of admin but nowadays

there are platforms that allow retail

investors to access funds like this so

the question is should you be using them

well firstly private Equity Funds are

still very high risk they are a liquid

so you may not get your money back for 5

or 10 years and they tend to have very

high fees a 2020 study reported that the

average fees for a private Equity Fund

was the equivalent of 6% per year that

is why private Equity is known as the

billionaire Factory because these

managers make so much money for

themselves but what about their

investors ultimately fees are irrelevant

if the performance is still good and

there is evidence that private Equity

Funds have in aggregate outperformed

public market stocks in the past however

there is a huge amount of dispersion

within those results with one study

finding that the top performing quara

funds would have left you the equivalent

of 81% better off than investing in the

S&P 500 over their lifetime which tends

to be about 5 years whereas the bottom

quarter would have left you down 32% for

Venture Capital it's even wider with the

top quarter outperforming the S&P by

111% and the bottom quartal down 57

which shows just how important it is to

make sure that you invest in a good fund

but this study also showed that of the

private Equity managers whose previous

fund was in the top quarti only 34% of

them went on to raise another fund that

was in the top quarti showing that as

ever when it comes to actively managed

funds past performance is not a Rel

indicator of future results so how are

you supposed to identify a good Fund in

advance a well-known saying is that the

only way to find a good private Equity

Fund is to find one that won't take your

money because the best funds tend to be

small and so exclusive that even

extremely wealthy people struggle to get

into them so clearly investing in

private Equity is high risk produces

unpredictable returns and is difficult

for retail investors to access however

in the UK the government offers generous

tax incentives to retail investors to

encourage them to invest in small

Innovative businesses and these schemes

make investing in private companies more

attractive and accessible so there are

certain situations that I do recommend

these types of solutions to my clients

but it is still only ever for people

that are comfortable with the risks

people that already have a large amount

of liquid assets and even then would

only be looking to invest up to 10% of

their overall portfolio into these

higher risk Investments now what about

hedge funds hedge fund is a term used to

refer to a wide variety of different

funds some of which are designed to

deliver returns that are less correlated

with traditional stocks and bonds and

can help to diversify a portfolio whilst

others tend to be absolute return funds

that use tactics like short selling to

try and produce positive returns no

matter where the markets are rising or

falling it's hard to make

generalizations about hedge funds

because there are so many different use

cases however the one thing that seems

to be consistent is their High fees most

hedge funds charge a fee of 2% per year

plus a 20% performance fee but a

fascinating paper found that investors

actually end up losing about 50% of

their returns to Performance fees hedge

fund investors typically invest in more

than one fund and as an example over a

period of time some of those funds may

do well and you'll pay performance fees

there and others won't perform well but

from your perspective across your whole

portfolio you may end up paying away

much more than 20% of your gains in

performance fees and what kind of

performance should we expect here we

have the risk and return of publicly

traded US Stocks bonds and a 60/40

portfolio over the last 20 years and

here is the average performance of the

hedge funds in each of these categories

so you can see that the return

characteristics are not that dissimilar

from bonds of course there will be some

funds Within These groups that have

performed better and this is not enough

information to dismiss hedge funds

entirely but this is the thing

alternative Investments as a whole are

often high risk they have high fees and

they are complicated as hell so for us

retail investors to even think about

investing in this stuff there would need

to be some very clear compelling

advantages and there isn't even for

wealthy people in fact I believe that

the reasons why the wealthy end up

investing in this stuff are often

irrational let's say you're someone like

Roger federa someone who comes from a

world where the more skillful you are

and the more effort you put in the

better the results that you get when

Roger goes looking to invest his money

he's not likely to want to settle for

the average return of an index fund that

any man on the street can get he's going

to seek out the best most exclusive

often most expensive investment advisers

who will offer him up these complex

Solutions and smart people like Roger

love nothing more than complex Solutions

but in reality investing is

counterintuitive and it's typically the

most simple lowest cost solutions that

are the easiest to stick with that

provide the best results so in my

opinion a simple globally Diversified

lowcost stock and bond portfolio should

get you 95% of the way there the rest of

this stuff is just icing on the cake and

is best ignored