By Dr. Charles Patterson, WCI Columnist
While Moderate-Income Physicians face unique challenges on the journey to financial independence, one that may surprise them is the realization that, along the way, they became an accredited investor. The SEC defines an accredited investor as an individual with a net worth of greater than $1 million (not including the value of their primary residence) or with an income exceeding $200,000 in each of the previous two years ($300,000 for those filing jointly). Other provisions add to the definition (including those for trusts, LLCs, etc). Implications of qualification can be profound with regard to the accessibility of new investment opportunities. Since us moderate income types have a diverse range of income and career circumstances, one can surmise that many are or will fit the definition of accredited investor at some point in their financial lives.
The economic and behavioral principles that accompany accredited investor status are best planned for in advance. In the first place, a type of recency bias may lull an individual into believing that their net worth or income are unchanging. When an unexpected windfall, a compensation change, or a promotion rocket you to the upper echelon of private investors, it's helpful to have walked through the use of those resources in advance. For some, the change in financial category may be intimidating, even uncomfortable; for others, it may induce pride or overconfidence. Either response could be deleterious to the prudent application of those funds.
The following paragraphs will explore these concepts with the goal of understanding our priorities as they pertain to changes in our financial lives.
What Does It Mean to Become an Accredited Investor?
As written, the SEC (as directed by the Code of Federal Regulation, Title 17) defines an individual investor as accredited by virtue of income limits or net worth. Of note, the SEC’s calculation for net worth differs from most of us by virtue of the exclusion of home value. While the numbers are likely to increase, the concept is unchanged. Those who enjoy accredited investor status have access to specific investment opportunities—which include exempt or private offerings, hedge funds, private equity forays, and certain real estate investments (among many others).
In general, these investments carry large minimums and at least have the luster of higher returns. Where there are prospects of higher returns, of course, there is the specter of higher risk. Part of the reason that the SEC mandates an accredited status is to protect those of us with lower incomes from participating in strategies that can devastate quickly. The caution here is that if you have worked for 10 or 20 or more years to build a net worth north of $1 million, the deeper waters of “private offerings” can drown you quickly. Tread carefully.
The term “accredited investor” is a legal definition with real behavioral implications. Qualifying as an accredited investor implies that your financial behavior has elevated you to a level of security or sophistication worthy of “the next level.” That may be true for others, but it is certainly not true for me. A plan is involved in my financial life, but success is predicated on budgeting, saving, and a passive investment approach—not my deftness in navigating the markets. There has been no seed-round participation, no syndicated real estate, or any such vehicle. To pretend that qualification for these investments is tantamount to an SEC-stamped credentialing would be a fallacy.
Secondly, we should be careful not to conflate a desire for diversification with clever means of risk mitigation. With larger investable sums, one would (correctly) desire to alleviate equities risk while gaining exposure to disparate, less correlated markets. Diversification is great, but risk is unavoidable as long as you are playing the game. Vetting the actual risk of these newly available vehicles against the benefits of their alternatives isn’t particularly straightforward. Calculating operating costs, deciphering the liquidity premium, and understanding the associated tax burden are but a few new tasks to accompany your shiny new investment. No doubt, there is a reason that folks (even and especially some brilliant and sophisticated investors) pursue them. But just because you’ve reached the greener grass on the other side doesn’t mean that there won’t be weeds.
In this new territory, knowing which are advisable and which are not can be a time-consuming, expensive, and fraught misadventure. Even Mike Tyson can tell you that status does not equal savviness; just because you are an accredited investor doesn’t mean you have the skills to successfully traverse a new universe of investments.
As it stands, the SEC definition is fairly lax. While the masses will take no pity on us for foolishly pursuing a poor investment, legal recourse in the absence of blatant fraud is more onerous (and expensive). This can pose a bit of a conundrum for the moderate income physicians seeking a clever way ahead. Unlike using leverage, options, and futures—which are comparatively slow processes that involve many transactions—the relative damage one can do to a portfolio with a single lemon as an accredited investor is impressive. As WCI founder Dr. Jim Dahle has said regarding the SEC definition:
“Personally, I think those dollar figures are way too low. They haven't changed in years. I would double them, and you ought to meet BOTH of the requirements. That is, you should have BOTH an income of $400,000+ AND investable assets of $2 million+.”
I agree wholeheartedly, and I take it as a warning.
More information here:
A Moderate-Income Physician’s Approach to Alternative Investments
Here’s How Much We Make, Save, and Spend as ‘Moderate Earners’
Should Becoming an Accredited Investor Change Your Written Financial Plan?
The underlying philosophical question relates to how larger sums should be invested. This, of course, presumes that an investing strategy should change at all. A reasonable reconciliation may include provisions that your written investment plan will evolve in “X” ways when “Y” conditions have been met. A more robust and resilient investment plan should always be considered, but each iteration or revision of the plan should also immunize you from future change. From this perspective, reaching accredited investor status should be an occasion that is anticipated and, frankly, uneventful. This is not to insinuate that reaching this milestone is not to be celebrated but rather that you will know exactly what you are going to do once it is achieved.
Financial success is, to an unknowable degree, incumbent on the thoroughness of contingency planning. This planning considers conditions that deplete wealth, which is why we preach about the importance of insuring against catastrophe and emergency preparedness. In a similar way, windfalls, pay increases, and status changes should also be the subject of careful forethought. A pre-constructed framework for managing each is a useful tool for optimally aligning priorities and resources.
Briefly, this framework should incorporate a re-evaluation of debt (and comfort with the same), savings goals, and timelines for achieving them. Your priorities probably differ in some way from your colleagues, and they may even differ from your significant other. More money doesn’t have to mean more problems; it can and should be a mechanism for strengthening relationships and fostering gratitude. Creating a “contingency budget” is an exercise that accomplishes the goal of placing excess income in its proper, most useful place. Those of us who occasionally dream of winning the lottery are familiar with this game. There are many right answers (and some wrong ones), but the true value lies in garnering a deeper understanding of your financial priorities. How access to a broader world of investment opportunities fits into these priorities is a question worth exploring before their availability.
My contingency planning is milquetoast, thorough, and likely different to some degree from the next person. Accredited investor status doesn’t do much for me. I have a hard enough time getting through a prospectus or annual report, and I am certainly not proficient (or confident) enough to scrutinize a new investment opportunity.
It is said that fortune favors the bold. I say rubbish: fortune favors the patient.
More information here:
The Semantics of Finance and How to Tune Out All the Noise
The Bottom Line
Knowing where your money is going and will go in the event of change is foundational to an idealized, stress-mitigated financial life. Life is whacky. Circumstances evolve, devolve, and pivot. At the risk of falling down the rabbit hole of what-ifs, creating a broad-strokes outline for the ups and downs and in-betweens may save you the heartburn associated with making decisions in the moment. Regardless of whether you are a newly minted resident or a pentamillionaire, the peace of mind that accompanies planning is priceless. Arriving at accredited investor status is a life event that is to be celebrated, but it should only change your investing behavior in a preordained way.
Finally, a word of gratitude. Accredited investor status is but one in a long list of possible but non-mandatory attributes that describe financial success. Some moderate income physicians will qualify before others, and that is great. But as I argue for the importance of these discussions, I find it grounding to remind myself of the unmeasurable impact of financial literacy. So many of our patients and some of our peers struggle mightily through circumstances and behaviors that affect their minds as much as their bank accounts.
The act of planning is priceless, and it can have a tremendous impact on our mental health and wellness. An ounce of written prevention is worth a pound of cure. Regardless of income, net worth, or current status, better decisions and a stronger financial future are achievable through planning. I am thankful for communities like this one which promote financial literacy and help us make more careful, informed, and responsible decisions.
How do you think about being an accredited investor? Has it made you more bold? Or do you follow the same plan you had before? If you're not there yet, what are your plans for when you become an accredited investor?
I’m starting to find that alternate investments are too much trouble vs stocks and bonds unless you have $5M+ and are really concerned about diversification. The K-1s and associated tax complexity, time needed to do due-diligence on alts, the need for different accounts for each alt investement to subscribe/track/manage your alternatives, etc. make it a headache to own. I also haven’t seen definitive proof that alternates, on average, generate superior results to publicly traded investments so the primary value I see in alts is diversification.
Hey Charles, nice piece man. Yeah definitely I wish the accredited Investor requirements were much stricter given the risk and lack of transparency that a lot of these investments have. I think it’s kind of silly that it’s based on income at all. The real criteria should be more knowledge based and you should really be able to pass a basic financial literacy test before investing in some of these very complex deals.
We should think of the opportunity of being an accredited investor as something that becomes available to make a certain income because by reaching that threshold, it can be assumed that they are intelligent enough to know to do their own research. While we all know this isn’t the case, that smarter people can make much less, and luckier people can make much more.
Maybe it makes more sense to think of the net worth/income threshold as a way to protect the masses.
The conclusion I draw from my experience being an accredited investor in a couple of cases is it protects the broker selling you whatever it is you need to be an accredited investor in order to buy. By being one you are smart enough to obtain and understand all the disclosure you need to do something that might turn out to be really stupid.