Mellody is President of Ariel investments, a Chicago-based money management firm that serves individual investors and retirement plans through its no-load mutual funds and separate accounts. Additionally, she is a regular financial contributor and analyst for CBS news.
Tom: This morning we are talking about recent investment fads. Can you tell us what do you mean by investment fad?
Mellody: These investment fads are recent trends, but not in the sense that the market has been trending up or down. What we are talking about this morning are buzzword investing strategies you may have heard of on the news in the last few years – such as crowd funding, impact investing or locavesting – and what you need to know before you jump on the band wagon.
Tom: I have certainly heard a lot about crowd funding, so let’s start there. What is crowd funding, exactly?
Mellody: It is pretty straightforward – it is a method of financing something by raising money in small amounts from a large group of people. the practice really started off as the domain of creative pursuits, such as artists, musicians and other performers, and it was initially a reward-based venture with funders or ‘backers’ simply contributing to projects for personal satisfaction or other non-financial benefits. However, more recently crowd funding has made the jump to equity models, meaning that individuals are now launching projects where investors receive stake in companies and their profits. The biggest confirmation of the momentum of this practice came with the passage of the jobs act in 2012. the act modified U.S. securities laws, increasing the number of investors a private firm may have, to 2,000 from 500, eliminating some hurdles for companies seeking initial public offerings, lifting the “general solicitation” ban preventing entrepreneurs from advertising sales of equity in their small, private companies to wealthy individuals, known as “accredited investors,” and – pending sec rules – allowing small companies to raise funds from average investors online through crowd funding.
Tom: Ok, so what are the pros and cons of crowd funding if you are an investor?
Mellody: The pros of crowd funding are pretty simple – access to capital, fewer regulatory hurdles, and harnessing the power of numbers come to mind. But the positives fall almost exclusively to the project’s owner, not those who are investing in it. The cons are numerous, and they are borne mostly by the investor. for example, at this point companies that use the crowd funding process to raise capital have a much lower threshold to meet when it comes to transparency, which handicaps an investor’s ability to perform due diligence.
Another thing to be very cognizant of is that crowd funding that is billed as a chance to get in on the ground is very risky. Very few novice investors make good investment returns. I have mentioned this a number of times: the average person investing for themselves has returns far below those of an investment company, and that’s true even for those who are lucky enough to have a huge winner in their portfolio. In general, venture capital has had fairly modest returns over the past decade, and this is money managed by professional investors with huge experience in identifying young companies with positioned for success. A lot of new companies fail, and chances are you are not going to be getting in on the ground floor of the next Google, and you might lose big.
Tom: Ok. What about other trendy investment models?
Mellody: Another model out there that has been gaining a lot of attention is impact investing. Impact investing is a kind of socially responsible investing, which we have talked about on money Monday before. This is where investors provide capital to businesses, nonprofits and funds that harness enterprise to address social and environmental challenges. The goal is to produce positive results beyond strictly financial returns. This is an admirable goal, and it is often successful. But here is the thing, tom: our listeners need to consider their financial goals first and foremost, particularly when it comes to returns. While a number of studies have showed that socially responsible investments have performed well when compared with other funds, there are some risks. Impact investments can have higher management fees associated with them, and may not be the best option for long-term growth. Unless you are already well positioned financially, impact investing may not be the way to go for everyday investors who are looking to build their retirement accounts.
Tom: You mentioned locavesting. What, exactly, is that?
Mellody: locavesting, or local investing, is probably the newest of the fads out there, and the one that people are least familiar with. The stated purpose of local investing is to directly invest in ventures within your community. This is usually through a local fund that provides grants to entrepreneurs and small businesses in a certain area. The most important thing to know about these is that it is much harder to evaluate the prospects of businesses that apply for these loans, because more often than not they do not have a long financial history. Also, many of these community funds have a minimum commitment term, some as long as 5 years, which means you will not have access to your money over that time period. Finally, while some of these funds generate respectable returns, they are much more volatile and risky than your average mutual fund. If you wanted to invest in something like this, you want to make sure that you do not need access to that money, and that it is a very small portion of your portfolio – no more than 5%.
Tom: Alright, what is the big picture takeaway from this?
Mellody: Well, Tom, the biggest takeaway is that you need to make sure you are considering all the facts when thinking about your investments. While rolling the dice on a new company through crowd funding or supporting local investments may be admirable ventures, it may not be the best strategy for your money. In the end, the most important venture out there is your long-term financial health and preparedness. So, if you want to embrace one of these strategies such as impact investing, just make sure that you know the facts, make sure you are aware of the risks, and are very aware of how it might affect your long-term investment goals and returns.