Who is a sophisticated investor?

The investment world is split into two categories, retail and institutional. Retail is basically all of us little guys who rarely have $1 million or even $250,000 to "invest." Institutional includes pension funds, financial institutions, governments, and so-called "sophisticated" or high net worth individuals. Institutional investors are usually offerred higher rates of return and access to risky investments such as hedge funds on the theory that they are "sophisticated" enough to understand the higher levels of risks. Or at least that is the theory.

Alas, having a larger pile of money is not a very reliable indicator of sophistication and ability to adequately assess risk. To wit, we have seen numerous news stories in recents months about municipalities and even charities, not to mention large financial institutions, who have gotten screwed because they had no idea of the significantly higher risks with mortgage-backed securities and derivative securities and pseudo-money market funds such as cash-management vehicles, investment pools, and so-called "enhanced cash" funds. In truth, the only difference between your average municipality and your average retail investor is that the former have crossed the dollar-level threshold to be considered "sophisticated" (and that they are technically "institutions" as well.) Sure, a municipality can hire a consultant to advise on risk, but I suspect that the overall packaging and slick claims for these financial products coupled with "group think" lull even sharp city managers and financial analysts into believing that Wall Street "knows what it is doing" and that the products would not be offerred to them if they were too risky. Bad assumption.

The simple reality is that there is a wide swath of investors who are either institutional or simply have more than the threshold amount of money, but who still have too small an amount of money to hire the level of sophisticated risk managers who really can make technical sense out of the actual risk of many of the investments that are being peddled even today as "low risk." Rather than the financial threshold being at $1 million, I suspect it is closer to $100 million. If you have $25 million you can hire a full-time money manager, but they probably won't have the level of expertise to have understood bank SIV conduit risks over a year ago. Maybe at $50 million to $75 million you can hire a team of specialists, but still without the hard-core risk assessment skill needed to laser-drill through dense, opaque security documents. Somewhere closer to $100 million you can finally afford to bring in the elite levels of risk managers (ala Goldman Sachs) who could have told you exactly how Bear Stearns, Citigroup, and Merrill were at risk a couple of months before the liquidity problems became actual disasters. Sure, there were plenty of people touting subprime risk one, two, and even three years ago, a number of those people were also betting heavily on short-term sharp decline way too early. Sophisticated investors who invested in those early-bird short hedge funds lost as much if not more than some of the recent losses. Risk assessment does include a timing element.

Sure, now we are all so much more "sophisticated" than we were a year ago, but one does have to wonder what the term "sophisticated" even means when even Bear Stearns, Citigroup, and Merrill Lynch had so much difficulty with it.

So, tell me, how sophisticated an investor are you?

I did have a small amount of money in a pseudo-money market fund that invested primarily in floating rate high-yield corporate debt. It has lost money in terms of NAV, but actually not much more than the higher income that it pays out. At the time it sounded like a solid investment. I was quite aware of the risks with high-yield corporate debt, but the theory was that diversification over a large number of issuers would compensate for any defaults. That failed to account for the systemic risk of a wholesale writedown of all high-yield corporate debt that we are currently seeing. Maybe the lesson there is that even if you are relatively sophisticated, are you sophisticated enough for a particular investment.

Even if you are prepared for a rainy day, are you prepared for a cloudburst, flood, tornado, or hurricane?

-- Jack Krupansky