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How Venture Capital Works

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November-December 1998 Issue

Invention and innovation drive the U.S. economy. What’s more, they have a powerful grip on the nation’s collective imagination. The popular press is filled with against-all-odds success stories of Silicon Valley entrepreneurs. In these sagas, the entrepreneur is the modern-day cowboy, roaming new industrial frontiers much the same way that earlier Americans explored the West. At his side stands the venture capitalist, a trail-wise sidekick ready to help the hero through all the tight spots—in exchange, of course, for a piece of the action.

As with most myths, there’s some truth to this story. Arthur Rock, Tommy Davis, Tom Perkins, Eugene Kleiner, and other early venture capitalists are legendary for the parts they played in creating the modern computer industry. Their investing knowledge and operating experience were as valuable as their capital. But as the venture capital business has evolved over the past 30 years, the image of a cowboy with his sidekick has become increasingly outdated. Today’s venture capitalists look more like bankers, and the entrepreneurs they fund look more like M.B.A.’s.

The U.S. venture-capital industry is envied throughout the world as an engine of economic growth. Although the collective imagination romanticizes the industry, separating the popular myths from the current realities is crucial to understanding how this important piece of the U.S. economy operates. For entrepreneurs (and would-be entrepreneurs), such an analysis may prove especially beneficial.

Profile of the Ideal Entrepreneur

From a venture capitalist’s perspective, the ideal entrepreneur:

  • is qualified in a “hot” area of interest,
  • delivers sales or technical advances such as FDA approval with reasonable probability,
  • tells a compelling story and is presentable to outside investors,
  • recognizes the need for speed to an IPO for liquidity,
  • has a good reputation and can provide references that show competence and skill,
  • understands the need for a team with a variety of skills and therefore sees why equity has to be allocated to other people,
  • works diligently toward a goal but maintains flexibility,
  • gets along with the investor group,
  • understands the cost of capital and typical deal structures and is not offended by them,
  • is sought after by many VCs,
  • has realistic expectations about process and outcome.

Venture Capital Fills a Void

Contrary to popular perception, venture capital plays only a minor role in funding basic innovation. Venture capitalists invested more than $ 10 billion in 1997, but only 6 % , or $ 600 million, went to startups. Moreover, we estimate that less than $ 1 billion of the total venture-capital pool went to R&D. The majority of that capital went to follow-on funding for projects originally developed through the far greater expenditures of governments ( $ 63 billion) and corporations ( $ 133 billion).

Where venture money plays an important role is in the next stage of the innovation life cycle—the period in a company’s life when it begins to commercialize its innovation. We estimate that more than 80 % of the money invested by venture capitalists goes into building the infrastructure required to grow the business—in expense investments (manufacturing, marketing, and sales) and the balance sheet (providing fixed assets and working capital).

Venture money is not long-term money. The idea is to invest in a company’s balance sheet and infrastructure until it reaches a sufficient size and credibility so that it can be sold to a corporation or so that the institutional public-equity markets can step in and provide liquidity. In essence, the venture capitalist buys a stake in an entrepreneur’s idea, nurtures it for a short period of time, and then exits with the help of an investment banker.

Venture capital’s niche exists because of the structure and rules of capital markets. Someone with an idea or a new technology often has no other institution to turn to. Usury laws limit the interest banks can charge on loans—and the risks inherent in start-ups usually justify higher rates than allowed by law. Thus bankers will only finance a new business to the extent that there are hard assets against which to secure the debt. And in today’s information-based economy, many start-ups have few hard assets.

Furthermore, investment banks and public equity are both constrained by regulations and operating practices meant to protect the public investor. Historically, a company could not access the public market without sales of about $ 15 million, assets of $ 10 million, and a reasonable profit history. To put this in perspective, less than 2 % of the more than 5 million corporations in the United States have more than $ 10 million in revenues. Although the IPO threshold has been lowered recently through the issuance of development-stage company stocks, in general the financing window for companies with less than $ 10 million in revenue remains closed to the entrepreneur.

Venture capital fills the void between sources of funds for innovation (chiefly corporations, government bodies, and the entrepreneur’s friends and family) and traditional, lower-cost sources of capital available to ongoing concerns. Filling that void successfully requires the venture capital industry to provide a sufficient return on capital to attract private equity funds, attractive returns for its own participants, and sufficient upside potential to entrepreneurs to attract high-quality ideas that will generate high returns. Put simply, the challenge is to earn a consistently superior return on investments in inherently risky business ventures.

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Sufficient Returns at Acceptable Risk

Investors in venture capital funds are typically very large institutions such as pension funds, financial firms, insurance companies, and university endowments—all of which put a small percentage of their total funds into high-risk investments. They expect a return of between 25 % and 35 % per year over the lifetime of the investment. Because these investments represent such a tiny part of the institutional investors’ portfolios, venture capitalists have a lot of latitude. What leads these institutions to invest in a fund is not the specific investments but the firm’s overall track record, the fund’s “story,” and their confidence in the partners themselves.

How do venture capitalists meet their investors’ expectations at acceptable risk levels? The answer lies in their investment profile and in how they structure each deal.

The Investment Profile.

One myth is that venture capitalists invest in good people and good ideas. The reality is that they invest in good industries—that is, industries that are more competitively forgiving than the market as a whole. In 1980, for example, nearly 20 % of venture capital investments went to the energy industry. More recently, the flow of capital has shifted rapidly from genetic engineering, specialty retailing, and computer hardware to CD-ROMs, multimedia, telecommunications, and software companies. Now, more than 25 % of disbursements are devoted to the Internet “space.” The apparent randomness of these shifts among technologies and industry segments is misleading; the targeted segment in each case was growing fast, and its capacity promised to be constrained in the next five years. To put this in context, we estimate that less than 10 % of all U.S. economic activity occurs in segments projected to grow more than 15 % a year over the next five years.

The myth is that venture capitalists invest in good people and good ideas. The reality is that they invest in good industries.

In effect, venture capitalists focus on the middle part of the classic industry S-curve. They avoid both the early stages, when technologies are uncertain and market needs are unknown, and the later stages, when competitive shakeouts and consolidations are inevitable and growth rates slow dramatically. Consider the disk drive industry. In 1983, more than 40 venture-funded companies and more than 80 others existed. By late 1984, the industry market value had plunged from $ 5.4 billion to $ 1.4 billion. Today only five major players remain.

Growing within high-growth segments is a lot easier than doing so in low-, no-, or negative-growth ones, as every businessperson knows. In other words, regardless of the talent or charisma of individual entrepreneurs, they rarely receive backing from a VC if their businesses are in low-growth market segments. What these investment flows reflect, then, is a consistent pattern of capital allocation into industries where most companies are likely to look good in the near term.

During this adolescent period of high and accelerating growth, it can be extremely hard to distinguish the eventual winners from the losers because their financial performance and growth rates look strikingly similar. (See the chart “Timing Is Everything.”) At this stage, all companies are struggling to deliver products to a product-starved market. Thus the critical challenge for the venture capitalist is to identify competent management that can execute—that is, supply the growing demand.

Timing Is Everything More than 80% of the money invested by venture capitalists goes into the adolescent phase of a company’s life cycle. In this period of accelerated growth, the financials of both the eventual winners and losers look strikingly similar.

Picking the wrong industry or betting on a technology risk in an unproven market segment is something VCs avoid. Exceptions to this rule tend to involve “concept” stocks, those that hold great promise but that take an extremely long time to succeed. Genetic engineering companies illustrate this point. In that industry, the venture capitalist’s challenge is to identify entrepreneurs who can advance a key technology to a certain stage—FDA approval, for example—at which point the company can be taken public or sold to a major corporation.

By investing in areas with high growth rates, VCs primarily consign their risks to the ability of the company’s management to execute. VC investments in high-growth segments are likely to have exit opportunities because investment bankers are continually looking for new high-growth issues to bring to market. The issues will be easier to sell and likely to support high relative valuations—and therefore high commissions for the investment bankers. Given the risk of these types of deals, investment bankers’ commissions are typically 6 % to 8 % of the money raised through an IPO. Thus an effort of only several months on the part of a few professionals and brokers can result in millions of dollars in commissions.

As long as venture capitalists are able to exit the company and industry before it tops out, they can reap extraordinary returns at relatively low risk. Astute venture capitalists operate in a secure niche where traditional, low-cost financing is unavailable. High rewards can be paid to successful management teams, and institutional investment will be available to provide liquidity in a relatively short period of time.

The Logic of the Deal.

There are many variants of the basic deal structure, but whatever the specifics, the logic of the deal is always the same: to give investors in the venture capital fund both ample downside protection and a favorable position for additional investment if the company proves to be a winner.

In a typical start-up deal, for example, the venture capital fund will invest $ 3 million in exchange for a 40 % preferred-equity ownership position, although recent valuations have been much higher. The preferred provisions offer downside protection. For instance, the venture capitalists receive a liquidation preference. A liquidation feature simulates debt by giving 100 % preference over common shares held by management until the VC’s $ 3 million is returned. In other words, should the venture fail, they are given first claim to all the company’s assets and technology. In addition, the deal often includes blocking rights or disproportional voting rights over key decisions, including the sale of the company or the timing of an IPO.

The contract is also likely to contain downside protection in the form of antidilution clauses, or ratchets. Such clauses protect against equity dilution if subsequent rounds of financing at lower values take place. Should the company stumble and have to raise more money at a lower valuation, the venture firm will be given enough shares to maintain its original equity position—that is, the total percentage of equity owned. That preferential treatment typically comes at the expense of the common shareholders, or management, as well as investors who are not affiliated with the VC firm and who do not continue to invest on a pro rata basis.

Alternatively, if a company is doing well, investors enjoy upside provisions, sometimes giving them the right to put additional money into the venture at a predetermined price. That means venture investors can increase their stakes in successful ventures at below market prices.

How the Venture Capital Industry Works The venture capital industry has four main players: entrepreneurs who need funding; investors who want high returns; investment bankers who need companies to sell; and the venture capitalists who make money for themselves by making a market for the other three.

VC firms also protect themselves from risk by coinvesting with other firms. Typically, there will be a “lead” investor and several “followers.” It is the exception, not the rule, for one VC to finance an individual company entirely. Rather, venture firms prefer to have two or three groups involved in most stages of financing. Such relationships provide further portfolio diversification—that is, the ability to invest in more deals per dollar of invested capital. They also decrease the workload of the VC partners by getting others involved in assessing the risks during the due diligence period and in managing the deal. And the presence of several VC firms adds credibility. In fact, some observers have suggested that the truly smart fund will always be a follower of the top-tier firms.

Attractive Returns for the VC

In return for financing one to two years of a company’s start-up, venture capitalists expect a ten times return of capital over five years. Combined with the preferred position, this is very high-cost capital: a loan with a 58 % annual compound interest rate that cannot be prepaid. But that rate is necessary to deliver average fund returns above 20 % . Funds are structured to guarantee partners a comfortable income while they work to generate those returns. The venture capital partners agree to return all of the investors’ capital before sharing in the upside. However, the fund typically pays for the investors’ annual operating budget—2 % to 3 % of the pool’s total capital—which they take as a management fee regardless of the fund’s results. If there is a $ 100 million pool and four or five partners, for example, the partners are essentially assured salaries of $ 200,000 to $ 400,000 plus operating expenses for seven to ten years. (If the fund fails, of course, the group will be unable to raise funds in the future.) Compare those figures with Tommy Davis and Arthur Rock’s first fund, which was $ 5 million but had a total management fee of only $ 75,000 a year.

The real upside lies in the appreciation of the portfolio. The investors get 70 % to 80 % of the gains; the venture capitalists get the remaining 20 % to 30 % . The amount of money any partner receives beyond salary is a function of the total growth of the portfolio’s value and the amount of money managed per partner. (See the exhibit “Pay for Performance.”)

Pay for Performance

Thus for a typical portfolio—say, $ 20 million managed per partner and 30 % total appreciation on the fund—the average annual compensation per partner will be about $ 2.4 million per year, nearly all of which comes from fund appreciation. And that compensation is multiplied for partners who manage several funds. From an investor’s perspective, this compensation is acceptable because the venture capitalists have provided a very attractive return on investment and their incentives are entirely aligned with making the investment a success.

What part does the venture capitalist play in maximizing the growth of the portfolio’s value? In an ideal world, all of the firm’s investments would be winners. But the world isn’t ideal; even with the best management, the odds of failure for any individual company are high.

On average, good plans, people, and businesses succeed only one in ten times. To see why, consider that there are many components critical to a company’s success. The best companies might have an 80 % probability of succeeding at each of them. But even with these odds, the probability of eventual success will be less than 20 % because failing to execute on any one component can torpedo the entire company.

If just one of the variables drops to a 50 % probability, the combined chance of success falls to 10 % .

These odds play out in venture capital portfolios: more than half the companies will at best return only the original investment and at worst be total losses. Given the portfolio approach and the deal structure VCs use, however, only 10 % to 20 % of the companies funded need to be real winners to achieve the targeted return rate of 25 % to 30 % . In fact, VC reputations are often built on one or two good investments.

A typical breakout of portfolio performance per $ 1,000 invested is shown below:

Those probabilities also have a great impact on how the venture capitalists spend their time. Little time is required (and sometimes best not spent) on the real winners—or the worst performers, called numnuts (“no money, no time”). Instead, the VC allocates a significant amount of time to those middle portfolio companies, determining whether and how the investment can be turned around and whether continued participation is advisable. The equity ownership and the deal structure described earlier give the VCs the flexibility to make management changes, particularly for those companies whose performance has been mediocre.

Most VCs distribute their time among many activities (see the exhibit “How Venture Capitalists Spend Their Time”). They must identify and attract new deals, monitor existing deals, allocate additional capital to the most successful deals, and assist with exit options. Astute VCs are able to allocate their time wisely among the various functions and deals.

How Venture Capitalists Spend Their Time

Assuming that each partner has a typical portfolio of ten companies and a 2,000-hour work year, the amount of time spent on each company with each activity is relatively small. If the total time spent with portfolio companies serving as directors and acting as consultants is 40 % , then partners spend 800 hours per year with portfolio companies. That allows only 80 hours per year per company—less than 2 hours per week.

The popular image of venture capitalists as sage advisors is at odds with the reality of their schedules. The financial incentive for partners in the VC firm is to manage as much money as possible. The more money they manage, the less time they have to nurture and advise entrepreneurs. In fact, “virtual CEOs” are now being added to the equity pool to counsel company management, which is the role that VCs used to play.

Today’s venture capital fund is structurally similar to its late 1970s and early 1980s predecessors: the partnership includes both limited and general partners, and the life of the fund is seven to ten years. (The fund makes investments over the course of the first two or three years, and any investment is active for up to five years. The fund harvests the returns over the last two to three years.) However, both the size of the typical fund and the amount of money managed per partner have changed dramatically. In 1980, the average fund was about $ 20 million, and its two or three general partners each managed three to five investments. That left a lot of time for the venture capital partners to work directly with the companies, bringing their experience and industry expertise to bear. Today the average fund is ten times larger, and each partner manages two to five times as many investments. Not surprisingly, then, the partners are usually far less knowledgeable about the industry and the technology than the entrepreneurs.

The Upside for Entrepreneurs

Even though the structure of venture capital deals seems to put entrepreneurs at a steep disadvantage, they continue to submit far more plans than actually get funded, typically by a ratio of more than ten to one. Why do seemingly bright and capable people seek such high-cost capital?

Venture-funded companies attract talented people by appealing to a “lottery” mentality. Despite the high risk of failure in new ventures, engineers and businesspeople leave their jobs because they are unable or unwilling to perceive how risky a start-up can be. Their situation may be compared to that of hopeful high school basketball players, devoting hours to their sport despite the overwhelming odds against turning professional and earning million-dollar incomes. But perhaps the entrepreneur’s behavior is not so irrational.

Consider the options. Entrepreneurs—and their friends and families—usually lack the funds to finance the opportunity. Many entrepreneurs also recognize the risks in starting their own businesses, so they shy away from using their own money. Some also recognize that they do not possess all the talent and skills required to grow and run a successful business.

Most of the entrepreneurs and management teams that start new companies come from corporations or, more recently, universities. This is logical because nearly all basic research money, and therefore invention, comes from corporate or government funding. But those institutions are better at helping people find new ideas than at turning them into new businesses (see the exhibit “Who Else Funds Innovation?”). Entrepreneurs recognize that their upside in companies or universities is limited by the institution’s pay structure. The VC has no such caps.

Who Else Funds Innovation?

The venture model provides an engine for commercializing technologies that formerly lay dormant in corporations and in the halls of academia. Despite the $ 133 billion U.S. corporations spend on R&D, their basic structure makes entrepreneurship nearly impossible. Because R&D relies on a cooperative and collaborative environment, it is difficult, if not impossible, for companies to differentially reward employees working side by side, even if one has a brilliant idea and the other doesn’t. Compensation typically comes in the form of status and promotion, not money. It would be an organizational and compensation nightmare for companies to try to duplicate the venture capital strategy.

Furthermore, companies typically invest in and protect their existing market positions; they tend to fund only those ideas that are central to their strategies. The result is a reservoir of talent and new ideas, which creates the pool for new ventures.

For its part, the government provides two incentives to develop and commercialize new technology. The first is the patent and trademark system, which provides monopolies for inventive products in return for full disclosure of the technology. That, in turn, provides a base for future technology development. The second is the direct funding of speculative projects that corporations and individuals can’t or won’t fund. Such seed funding is expected to create jobs and boost the economy.

Although many universities bemoan the fact that some professors are getting rich from their research, remember that most of the research is funded by the government. From the government’s perspective, that is exactly what their $ 63 billion in R&D funding is intended to do.

The newest funding source for entrepreneurs are so-called angels, wealthy individuals who typically contribute seed capital, advice, and support for businesses in which they themselves are experienced. We estimate that they provide $ 20 billion to start-ups, a far greater amount than venture capitalists do. Turning to angels may be an excellent strategy, particularly for businesses in industries that are not currently in favor among the venture community. But for angels, these investments are a sideline, not a primary business.

Downsizing and reengineering have shattered the historical security of corporate employment. The corporation has shown employees its version of loyalty. Good employees today recognize the inherent insecurity of their positions and, in return, have little loyalty themselves.

Additionally, the United States is unique in its willingness to embrace risk-taking and entrepreneurship. Unlike many Far Eastern and European cultures, the culture of the United States attaches little, if any, stigma to trying and failing in a new enterprise. Leaving and returning to a corporation is often rewarded.

For all these reasons, venture capital is an attractive deal for entrepreneurs. Those who lack new ideas, funds, skills, or tolerance for risk to start something alone may be quite willing to be hired into a well-funded and supported venture. Corporate and academic training provides many of the technological and business skills necessary for the task while venture capital contributes both the financing and an economic reward structure well beyond what corporations or universities afford. Even if a founder is ultimately demoted as the company grows, he or she can still get rich because the value of the stock will far outweigh the value of any forgone salary.

By understanding how venture capital actually works, astute entrepreneurs can mitigate their risks and increase their potential rewards. Many entrepreneurs make the mistake of thinking that venture capitalists are looking for good ideas when, in fact, they are looking for good managers in particular industry segments. The value of any individual to a VC is thus a function of the following conditions:

  • the number of people within the high-growth industry that are qualified for the position;
  • the position itself (CEO, CFO, VP of R&D, technician);
  • the match of the person’s skills, reputation, and incentives to the VC firm;
  • the willingness to take risks; and
  • the ability to sell oneself.

Entrepreneurs who satisfy these conditions come to the table with a strong negotiating position. The ideal candidate will also have a business track record, preferably in a prior successful IPO, that makes the VC comfortable. His reputation will be such that the investment in him will be seen as a prudent risk. VCs want to invest in proven, successful people.

Just like VCs, entrepreneurs need to make their own assessments of the industry fundamentals, the skills and funding needed, and the probability of success over a reasonably short time frame. Many excellent entrepreneurs are frustrated by what they see as an unfair deal process and equity position. They don’t understand the basic economics of the venture business and the lack of financial alternatives available to them. The VCs are usually in the position of power by being the only source of capital and by having the ability to influence the network. But the lack of good managers who can deal with uncertainty, high growth, and high risk can provide leverage to the truly competent entrepreneur. Entrepreneurs who are sought after by competing VCs would be wise to ask the following questions:

  • Who will serve on our board and what is that person’s position in the VC firm?
  • How many other boards does the VC serve on?
  • Has the VC ever written and funded his or her own business plan successfully?
  • What, if any, is the VC’s direct operating or technical experience in this industry segment?
  • What is the firm’s reputation with entrepreneurs who have been fired or involved in unsuccessful ventures?

The VC partner with solid experience and proven skill is a true “trail-wise sidekick.” Most VCs, however, have never worked in the funded industry or have never been in a down cycle. And, unfortunately, many entrepreneurs are self-absorbed and believe that their own ideas or skills are the key to success. In fact, the VC’s financial and business skills play an important role in the company’s eventual success. Moreover, every company goes through a life cycle; each stage requires a different set of management skills. The person who starts the business is seldom the person who can grow it, and that person is seldom the one who can lead a much larger company. Thus it is unlikely that the founder will be the same person who takes the company public.

Ultimately, the entrepreneur needs to show the venture capitalist that his team and idea fit into the VC’s current focus and that his equity participation and management skills will make the VC’s job easier and the returns higher. When the entrepreneur understands the needs of the funding source and sets expectations properly, both the VC and entrepreneur can profit handsomely. • • •

Although venture capital has grown dramatically over the past ten years, it still constitutes only a tiny part of the U.S. economy. Thus in principle, it could grow exponentially. More likely, however, the cyclical nature of the public markets, with their historic booms and busts, will check the industry’s growth. Companies are now going public with valuations in the hundreds of millions of dollars without ever making a penny. And if history is any guide, most of these companies never will.

The system described here works well for the players it serves: entrepreneurs, institutional investors, investment bankers, and the venture capitalists themselves. It also serves the supporting cast of lawyers, advisers, and accountants. Whether it meets the needs of the investing public is still an open question.

Common Investor and Trader Blunders

Words of Caution for the Novice

Making mistakes is part of the learning process when it comes to trading or investing. Investors are typically involved in longer-term holdings and will trade in stocks, exchange-traded funds, and other securities. Traders generally buy and sell futures and options, hold those positions for shorter periods, and are involved in a greater number of transactions.

While traders and investors use two different types of trading transactions, they often are guilty of making the same types of mistakes. Some mistakes are more harmful to the investor, and others cause more harm to the trader. Both would do well to remember these common blunders and try to avoid them.

No Trading Plan

Experienced traders get into a trade with a well-defined plan. They know their exact entry and exit points, the amount of capital to invest in the trade and the maximum loss they are willing to take.

Beginner traders may not have a trading plan in place before they commence trading. Even if they have a plan, they may be more prone to stray from the defined plan than would seasoned traders. Novice traders may reverse course altogether. For example, going short after initially buying securities because the share price is declining—only to end up getting whipsawed.

Chasing After Performance

Many investors or traders will select asset classes, strategies, managers, and funds based on a current strong performance. The feeling that “I’m missing out on great returns” has probably led to more bad investment decisions than any other single factor.

If a particular asset class, strategy, or fund has done extremely well for three or four years, we know one thing with certainty: We should have invested three or four years ago. Now, however, the particular cycle that led to this great performance may be nearing its end. The smart money is moving out, and the dumb money is pouring in.

Not Regaining Balance

Rebalancing is the process of returning your portfolio to its target asset allocation as outlined in your investment plan. Rebalancing is difficult because it may force you to sell the asset class that is performing well and buy more of your worst-performing asset class. This contrarian action is very difficult for many novice investors.

However, a portfolio allowed to drift with market returns guarantees that asset classes will be overweighted at market peaks and underweighted at market lows—a formula for poor performance. Rebalance religiously and reap the long-term rewards.

Ignoring Risk Aversion

Do not lose sight of your risk tolerance or your capacity to take on risk. Some investors can’t stomach volatility and the ups and downs associated with the stock market or more speculative trades. Other investors may need secure, regular interest income. These low-risk tolerance investors would be better off investing in the blue-chip stocks of established firms and should stay away from more volatile growth and startup companies shares.

Remember that any investment return comes with a risk. The lowest risk investment available is U.S. Treasury bonds, bills, and notes. From there, various types of investments move up in the risk ladder, and will also offer larger returns to compensate for the higher risk undertaken. If an investment offers very attractive returns, also look at its risk profile and see how much money you could lose if things go wrong. Never invest more than you can afford to lose.

Forgetting Your Time Horizon

Don’t invest without a time horizon in mind. Think about if you will need the funds you are locking up into an investment before entering the trade. Also, determine how long—the time horizon—you have to save up for your retirement, a downpayment on a home, or a college education for your child.

If you are planning to accumulate money to buy a house, that could be more of a medium-term time frame. However, if you are investing to finance a young child’s college education, that is more of a long-term investment. If you are saving for retirement 30 years hence, what the stock market does this year or next shouldn’t be the biggest concern.

Once you understand your horizon, you can find investments that match that profile.

Not Using Stop-Loss Orders

A big sign that you don’t have a trading plan is not using stop-loss orders. Stop orders come in several varieties and can limit losses due to adverse movement in a stock or the market as a whole. These orders will execute automatically once perimeters you set are met.

Tight stop losses generally mean that losses are capped before they become sizeable. However, there is a risk that a stop order on long positions may be implemented at levels below those specified should the security suddenly gap lower—as happened to many investors during the Flash Crash. Even with that thought in mind, the benefits of stop orders far outweigh the risk of stopping out at an unplanned price.

A corollary to this common trading mistake is when a trader cancels a stop order on a losing trade just before it can be triggered because they believe that the price trend will reverse.

Letting Losses Grow

One of the defining characteristics of successful investors and traders is their ability to take a small loss quickly if a trade is not working out and move on to the next trade idea. Unsuccessful traders, on the other hand, can become paralyzed if a trade goes against them. Rather than taking quick action to cap a loss, they may hold on to a losing position in the hope that the trade will eventually work out. A losing trade can tie up trading capital for a long time and may result in mounting losses and severe depletion of capital.

Averaging Down or Up

Averaging down on a long position in a blue-chip stock may work for an investor who has a long investment horizon, but it may be fraught with peril for a trader who is trading volatile and riskier securities. Some of the biggest trading losses in history have occurred because a trader kept adding to a losing position, and was eventually forced to cut the entire position when the magnitude of the loss became untenable. Traders also go short more often than conservative investors and tend toward averaging up, because the security is advancing rather than declining. This is an equally risky move that is another common mistake made by a novice trader.

The Importance of Accepting Losses

Far too often investors fail to accept the simple fact that they are human and prone to making mistakes just as the greatest investors do. Whether you made a stock purchase in haste or one of your long-time big earners has suddenly taken a turn for the worse, the best thing you can do is accept it. The worst thing you can do is let your pride take priority over your pocketbook and hold on to a losing investment. Or worse yet, buy more shares of the stock. as it is much cheaper now.

This is a very common mistake, and those who commit it do so by comparing the current share price with the 52-week high of the stock. Many people using this gauge assume that a fallen share price represents a good buy. However, there was a reason behind that drop and price and it is up to you to analyze why the price dropped.

Believing False Buy Signals

Deteriorating fundamentals, the resignation of a chief executive officer (CEO), or increased competition are all possible reasons for a lower stock price. These same reasons also provide good clues to suspect that the stock might not increase anytime soon. A company may be worth less now for fundamental reasons. It is important to always have a critical eye, as a low share price might be a false buy signal.

Avoid buying stocks in the bargain basement. In many instances, there is a strong fundamental reason for a price decline. Do your homework and analyze a stock’s outlook before you invest in it. You want to invest in companies that will experience sustained growth in the future. A company’s future operating performance has nothing to do with the price at which you happened to buy its shares.

Buying With Too Much Margin

Margin—using borrowed money from your broker to purchase securities, usually futures and options. While margin can help you make more money, it can also exaggerate your losses just as much. Make sure you understand how the margin works and when your broker could require you to sell any positions you hold.

The worst thing you can do as a new trader is become carried away with what seems like free money. If you use margin and your investment doesn’t go the way you planned, then you end up with a large debt obligation for nothing. Ask yourself if you would buy stocks with your credit card. Of course, you wouldn’t. Using margin excessively is essentially the same thing, albeit likely at a lower interest rate.

Further, using margin requires you to monitor your positions much more closely. Exaggerated gains and losses that accompany small movements in price can spell disaster. If you don’t have the time or knowledge to keep a close eye on and make decisions about your positions, and their values drop then your brokerage firm will sell your stock to recover any losses you have accrued.

As a new trader use margin sparingly, if at all; and only if you understand all of its aspects and dangers. It can force you to sell all your positions at the bottom, the point at which you should be in the market for the big turnaround.

Running With Leverage

According to a well-known investment cliché, leverage is a double-edged sword because it can boost returns for profitable trades and exacerbate losses on losing trades. Just as you shouldn’t run with scissors, you shouldn’t run to leverage. Beginner traders may get dazzled by the degree of leverage they possess—especially in forex (FX) trading—but may soon discover that excessive leverage can destroy trading capital in a flash. If a leverage ratio of 50:1 is employed—which is not uncommon in retail forex trading—all it takes is a 2% adverse move to wipe out one’s capital. Forex brokers like IG Group must disclose to traders that more than three-quarters of traders lose money because of the complexity of the market and the downside of leverage.

Following the Herd

Another common mistake made by new traders is that they blindly follow the herd; as such, they may either end up paying too much for hot stocks or may initiate short positions in securities that have already plunged and may be on the verge of turning around. While experienced traders follow the dictum of the trend is your friend, they are accustomed to exiting trades when they get too crowded. New traders, however, may stay in a trade long after the smart money has moved out of it. Novice traders may also lack the confidence to take a contrarian approach when required.

Keeping All Your Eggs in One Basket

Diversification is a way to avoid overexposure to any one investment. Having a portfolio made up of multiple investments protects you if one of them loses money. It also helps protect against volatility and extreme price movements in any one investment. Also, when one asset class is underperforming, another asset class may be performing better.

Many studies have proved that most managers and mutual funds underperform their benchmarks. Over the long term, low-cost index funds are typically upper second-quartile performers or better than 65%-to-75% of actively managed funds. Despite all of the evidence in favor of indexing, the desire to invest with active managers remains strong. John Bogle, the founder of Vanguard, says it’s because: “Hope springs eternal. Indexing is sort of dull. It flies in the face of the American way [that] “I can do better.'”

Index all or a large portion (70%-to-80%) of your traditional asset classes. If you can’t resist the excitement of pursuing the next great performer, then set aside about 20%-to-30% of each asset class to allocate to active managers. This may satisfy your desire to pursue outperformance without devastating your portfolio.

Shirking Your Homework

New traders are often guilty of not doing their homework or not conducting adequate research, or due diligence, before initiating a trade. Doing homework is critical because beginning traders do not have the knowledge of seasonal trends, or the timing of data releases, and trading patterns that experienced traders possess. For a new trader, the urgency to make a trade often overwhelms the need for undertaking some research, but this may ultimately result in an expensive lesson.

It is a mistake not to research an investment that interests you. Research helps you understand a financial instrument and know what you are getting into. If you are investing in a stock, for instance, research the company and its business plans. Do not act on the premise that markets are efficient and you can’t make money by identifying good investments. While this is not an easy task, and every other investor has access to the same information as you do, it is possible to identify good investments by doing the research.

Buying Unfounded Tips

Everyone probably makes this mistake at one point or another in their investing career. You may hear your relatives or friends talking about a stock that they heard will get bought out, have killer earnings or soon release a groundbreaking new product. Even if these things are true, they do not necessarily mean that the stock is “the next big thing” and that you should rush into your online brokerage account to place a buy order.

Other unfounded tips come from investment professionals on television and social media who often tout a specific stock as though it’s a must-buy, but really is nothing more than the flavor of the day. These stock tips often don’t pan out and go straight down after you buy them. Remember, buying on media tips is often founded on nothing more than a speculative gamble.

This isn’t to say that you should balk at every stock tip. If one really grabs your attention, the first thing to do is consider the source. The next thing is to do your own homework so that you know what you are buying and why. For example, buying a tech stock with some proprietary technology should be based on whether it’s the right investment for you, not solely on what a mutual fund manager said in a media interview.

Next time you’re tempted to buy based on a hot tip, don’t do so until you’ve got all the facts and are comfortable with the company. Ideally, obtain a second opinion from other investors or unbiased financial advisors.

Watching Too Much Financial TV

There is almost nothing on financial news shows that can help you achieve your goals. There are few newsletters that can provide you with anything of value. Even if there were, how do you identify them in advance?

If anyone really had profitable stock tips, trading advice, or a secret formula to make big bucks, would they blab it on TV or sell it to you for $49 per month? No. They’d keep their mouth shut, make their millions and not need to sell a newsletter to make a living. Solution? Spend less time watching financial shows on TV and reading newsletters. Spend more time creating—and sticking to—your investment plan.

Not Seeing the Big Picture

For a long-term investor, one of the most important but often overlooked things to do is a qualitative analysis or to look at the big picture. Legendary investor and author Peter Lynch once stated that he found the best investments by looking at his children’s toys and the trends they would take on. The brand name is also very valuable. Think about how almost everyone in the world knows Coke; the financial value of the name alone is therefore measured in the billions of dollars. Whether it’s about iPhones or Big Macs, no one can argue against real life.

So pouring over financial statements or attempting to identify buy and sell opportunities with complex technical analysis may work a great deal of the time, but if the world is changing against your company, sooner or later you will lose. After all, a typewriter company in the late 1980s could have outperformed any company in its industry, but once personal computers started to become commonplace, an investor in typewriters of that era would have done well to assess the bigger picture and pivot away.

Assessing a company from a qualitative standpoint is as important as looking at its sales and earnings. Qualitative analysis is a strategy that is one of the easiest and most effective for evaluating a potential investment.

Trading Multiple Markets

Beginning traders may tend to flit from market to market—that is, from stocks to options to currencies to commodity futures, and so on. Trading multiple markets can be a huge distraction and may prevent the novice trader from gaining the experience necessary to excel in one market.

Forgetting About Uncle Sam

Keep in mind the tax consequences before you invest. You will get a tax break on some investments such as municipal bonds. Before you invest, look at what your return will be after adjusting for tax, taking into account the investment, your tax bracket, and your investment time horizon.

Do not pay more than you need to on trading and brokerage fees. By holding on to your investment and not trading frequently, you will save money on broker fees. Also, shop around and find a broker that doesn’t charge excessive fees so you can keep more of the return you generate from your investment. Investopedia has put together a list of the best discount brokers to make your choice of a broker easier.

The Danger of Over-Confidence

Trading is a very demanding occupation, but the “beginner’s luck” experienced by some novice traders may lead them to believe that trading is the proverbial road to quick riches. Such overconfidence is dangerous as it breeds complacency and encourages excessive risk-taking that may culminate in a trading disaster.

From numerous studies, including Burton Malkiel’s 1995 study entitled: “Returns From Investing In Equity Mutual Funds,” we know that most managers will underperform their benchmarks. We also know that there’s no consistent way to select, in advance, those managers that will outperform. We also know that very few individuals can profitably time the market over the long term. So why are so many investors confident of their abilities to time the market and/or select outperforming managers? Fidelity guru Peter Lynch once observed: “There are no market timers in the Forbes 400.”

Inexperienced Day Trading

If you insist on becoming an active trader, think twice before day trading. Day trading can be a dangerous game and should be attempted only by the most seasoned investors. In addition to investment savvy, a successful day trader may gain an advantage with access to special equipment that is less readily available to the average trader. Did you know that the average day-trading workstation (with software) can cost in the tens of thousands of dollars? You’ll also need a sizable amount of trading money to maintain an efficient day-trading strategy.

The need for speed is the main reason you can’t effectively start day trading with the extra $5,000 in your bank account. Online brokers’ systems are not quite fast enough to service the true day trader; literally, pennies per share can make the difference between a profitable and losing trade. Most brokerages recommend that investors take day-trading courses before getting started.

Unless you have the expertise, a platform, and access to speedy order execution, think twice before day trading. If you aren’t very good at dealing with risk and stress, there are much better options for an investor who’s looking to build wealth.

Underestimating Your Abilities

Some investors tend to believe that they can never excel at investing because stock market success is reserved for sophisticated investors only. This perception has no truth at all. While any commission-based mutual fund salesmen will probably tell you otherwise, most professional money managers don’t make the grade either, and the vast majority underperform the broad market. With a little time devoted to learning and research, investors can become well-equipped to control their own portfolios and investing decisions, all while being profitable. Remember, much of investing is sticking to common sense and rationality.

Besides having the potential to become sufficiently skillful, individual investors do not face the liquidity challenges and overhead costs of large institutional investors. Any small investor with a sound investment strategy has just as good a chance of beating the market, if not better than the so-called investment gurus. Don’t assume that you are unable to successfully participate in the financial markets simply because you have a day job.

The Bottom Line

If you have the money to invest and are able to avoid these beginner mistakes, you could make your investments pay off; and getting a good return on your investments could take you closer to your financial goals.

With the stock market’s penchant for producing large gains (and losses), there is no shortage of faulty advice and irrational decision making. As an individual investor, the best thing you can do to pad your portfolio for the long term is to implement a rational investment strategy that you are comfortable with and willing to stick to.

If you are looking to make a big win by betting your money on your gut feelings, try a casino. Take pride in your investment decisions, and in the long run, your portfolio will grow to reflect the soundness of your actions.

Are High-Yield Bonds Safe?

Many high-risk bonds are not junk

Although they are considered risky investments, high-yield bonds—commonly known as junk bonds—may not deserve the negative reputation that still clings to them. In fact, the addition of these high-risk bonds to a portfolio can actually reduce overall portfolio risk when considered within the classic framework of diversification and asset allocation.

Let’s look more closely at what high-yield bonds are, what makes them risky, and why you may want to incorporate them into your investing strategy. High-yield bonds are available to investors as individual issues, through high-yield mutual funds, and as junk bond ETFs.

KEY TAKEAWAYS

  • High-yield bonds offer higher long-term returns than investment-grade bonds, better bankruptcy protections than stocks, and portfolio diversification benefits.
  • Unfortunately, the high-profile fall of “Junk Bond King” Michael Milken damaged the reputation of high-yield bonds as an asset class.
  • High-yield bonds face higher default rates and more volatility than investment-grade bonds, and they have more interest rate risk than stocks.
  • Emerging market debt and convertible bonds are the main alternatives to high-yield bonds in the high-risk debt category.
  • For the average investor, high-yield mutual funds and ETFs are the best ways to invest in junk bonds.

Understanding High-Yield Bonds

Generally, a high-yield bond is defined as a debt obligation with a bond rating of Ba or lower according to Moody’s or BB or lower on the Standard & Poor’s scale. In addition to being popularly known as junk bonds, they are also referred to as “below investment-grade.” Low ratings mean that the company’s financial situation is shaky. So, the possibility that the firm could miss making interest payments or default is higher than those of investment-grade bond issuers.

A bond classification below investment-grade does not necessarily mean that a company is mismanaged or engaged in fraud. Many fundamentally sound firms run into financial difficulties at various stages. One poor year for profits or a tragic chain of events can cause a company’s debt obligations to be downgraded. Some of the top companies in the S&P 500 have suffered the indignity of having their bonds downgraded to “junk” status. For example, in 2020, Moody’s downgraded the debt issued by automotive icon Ford to below investment-grade.

The opposite can also happen. The bonds issued by a young or newly public company may be low-rated because the firm does not yet have a long track record or financial results to evaluate.

Whatever the reason, being considered less creditworthy means borrowing money is more expensive for these companies. They have to pay more interest on their debt, the same way individuals with low credit scores often pay a higher APR on their credit cards. Therefore, they are called high-yield bonds. They offer higher interest rates because of the additional risks.

Advantages of High-Yield Bonds

Higher Returns

As a result of the increased interest rates, high-yield investments have generally produced better returns than investment-grade bonds. High-yield bonds also have higher returns than CDs and government bonds in the long run. If you are looking to get a higher yield within your fixed-income portfolio, keep that in mind. The number one advantage of high-yield bonds is income.

Bankruptcy Protections

Many investors are unaware of the fact that debt securities have an advantage over equity investments if a company goes bankrupt. Should this happen, bondholders would be paid first during the liquidation process, followed by preferred stockholders, and lastly, common stockholders. This added safety can prove valuable in protecting your portfolio from significant losses, reducing the damage from defaults.

Diversification

The performance of high-yield bonds does not correlate exactly with either investment-grade bonds or stocks. Because their yields are higher than investment-grade bonds, they’re less vulnerable to interest rate shifts. This is especially true at lower levels of credit quality, and high-yield bonds are similar to stocks in relying on the strength of the economy. Because of this low correlation, adding high-yield bonds to your portfolio can be an excellent way to reduce overall portfolio risk.

High-yield bonds can act as a counterweight to assets that are more sensitive to interest-rate movements or overall stock market trends. For example, high-yield bonds as a group lost far less than stocks during the financial crisis in 2008. They also rose in price as long-term Treasury bonds fell in 2009, and high-yield bond funds generally outperformed stocks during that market rebound.

The Bad Reputation of High-Yield Bonds

If they have so many pluses, why are high-yield bonds derided as junk? Unfortunately, the high-profile fall of “Junk Bond King” Michael Milken damaged the reputation of high-yield bonds as an asset class.

During the 1980s, Michael Milken—then an executive at investment bank Drexel Burnham Lambert Inc.—gained notoriety for his work on Wall Street. He greatly expanded the use of high-yield debt in mergers and acquisitions, which in turn fueled the leveraged buyout boom. Milken made millions of dollars for himself and his Wall Street firm by specializing in bonds issued by fallen angels. Fallen angels are once-sound companies that experienced financial difficulties that caused their credit ratings to fall.

In 1989, Rudolph Giuliani charged Milken under the RICO Act with 98 counts of racketeering and fraud. After a plea bargain, he served 22 months in prison and paid over $600 million in fines and civil settlements.

Today, many on Wall Street will attest that the negative perception of junk bonds persists because of the questionable practices of Milken and other highflying financiers like him.

Risks of High-Yield Bonds

Default Risk

High-yield investments also have their disadvantages, and investors must consider higher volatility and the risk of default at the top of the list. According to Fitch Ratings, high-yield bond defaults in the U.S. fell to 1.8% in 2020. However, the rising level of corporate indebtedness around the world troubles many analysts and economists. High-yield default rates in the U.S. reached 14% during the last recession in 2009, and they are very likely to rise again during the next downturn,

You should be aware that default rates for high-yield mutual funds are easily manipulated by managers. They have the flexibility to dump bonds before defaults and replace them with new bonds.

How can you more accurately estimate the default rate of a high-yield fund? You could look at what has happened to the fund’s total return during past downturns. If the fund’s turnover is extremely high (over 200%), this may be an indication that near-default bonds are being replaced frequently. You could also look at the fund’s average credit quality as an indicator. This can show you if the majority of the bonds being held are just below investment-grade quality at BB or B on the Standard & Poor’s scale. If the average is CCC or CC, then the fund is highly speculative because D indicates default.

You should be aware that default rates for high-yield mutual funds are easily manipulated by managers.

Interest Rate Risk

Another pitfall of high-yield investing is that a weak economy and rising interest rates can worsen yields. If you’ve ever invested in bonds in the past, you’re probably familiar with the inverse relationship between bond prices and interest rates. As interest rates go up, bond prices will go down. Though they are less sensitive to short-term rates, junk bonds closely follow long-term interest rates. After a long period of stability that kept investors’ principal investments intact, the Federal Reserve raised interest rates repeatedly in 2020 and 2020. However, the Fed reversed course and cut rates in 2020, leading to gains across the bond market.

During a bull market run, you might find that high-yield investments produce inferior returns when compared to equity investments. Fund managers may react to this slow bond market by turning over the portfolio. That will lead to higher turnover percentages and add additional fund expenses that are ultimately paid by you, the end investor.

In times when the economy is healthy, many managers believe that it would take a recession to plunge high-yield bonds into disarray. However, investors must still consider other risks, such as the weakening of foreign economies, changes in currency rates, and various political risks.

Alternatives to High-Yield Bonds

Emerging Market Debt

If you’re looking for some significant yield premiums, domestic junk bonds aren’t the only asset in the financial sea. Emerging market debt securities may be a beneficial addition to your portfolio. Typically, these securities are cheaper than their U.S. counterparts in part because they have much smaller domestic markets individually. As a group, they account for a significant portion of global high-yield markets.

Convertible Bonds

Some fund managers like to include convertible bonds of companies whose stock price has declined so much that the conversion option is practically worthless. These investments are commonly known as busted convertibles and are purchased at a discount since the market price of the common stock associated with the convertible has fallen sharply.

Other Alternatives

Many fund managers are given the flexibility to include certain other assets to help diversify their investments even further. High-dividend-yield common stocks and preferred shares are comparable to high-yield bonds because they generate substantial income. Certain warrants also have some of the speculative characteristics of junk bonds. Another possibility is leveraged bank loans. These are essentially loans that have a higher rate of interest to reflect the higher risk posed by the borrower.

The Bottom Line

For the average investor, high-yield mutual funds and ETFs are the best ways to invest in junk bonds. These funds offer a pool of low-rated debt obligations, and the diversification reduces the risk of investing in financially struggling companies.

Before you invest in high-yield bonds or other high-yield securities, you should be aware of the risks involved. After doing your research, you may want to add them to your portfolio if you feel these investments suit your situation. The potential to provide higher income and reduce overall portfolio volatility are both good reasons to consider high-yield investments.

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