What is an investment default?
One of the worst nightmares of any investor is to look at his/her investment portfolio and find a defaulted investment there. However, default is not the end of the world and should not be the reason for stopping investment activity.
The risk-free investment is a theoretical investment that carries no risks, and as risk-free investments don’t really exist, all investments carry some risk. Therefore, the absolute avoidance of investment risk and default events is statistically impossible. Whatever you do (or do not) as an investor will inevitably result in taking more or less risk. The longer is your investment experience and the larger the investment portfolio, the higher is the probability of experiencing an investment default or a loss of invested capital.
Default is the term that is used to describe a loan or an investment that has defaulted on one or more terms of the loan or investment contract. Failure to make a scheduled repayment is considered to be the most common default, the other default events include allowing the insurance to lapse on the property or collateral, the occurrence of tax debt, not making the scheduled progress on the project etc.
While the default is a clear sign of the specific investment not progressing as planned, it does not necessarily mean that the investor loses its original investment principal. In most cases, the real estate crowdfunding platform or its collateral agent is able to revive the investment via restructuring or, alternatively, collecting the debt via the enforcement or the collateral liquidation process. In the majority of cases, loans in default repay in full, often with higher interest than expected. In the worst-case scenario, especially when dealing with less liquid or overvalued collaterals or with unsecured junior or equity investments, the default could result in the partial or full loss of the original investment.
Default is not a reason for stopping investing
It is not uncommon for the less-experienced investors to be shocked by their first event of default and stop investing.
There is a lot of scientific research on such behaviour, and the term “sunk costs” has been coined to describe the investors’ tendency to make their investment decisions on the basis of historical events (which are irrelevant) instead of focusing on the future, prospective events (which are relevant).
The complete halt of the investment activities is probably the worst strategy. It results in suboptimal asset allocation and does not maximize the returns of the investable assets, which will result in the loss of purchasing power by being affected by inflation. Stopping all investment activities will also cement the investment loss permanently, not allowing the other assets in the investment portfolio to compensate for the loss arising from the defaulted investment.
The emotions arising from the sight of defaulted or lost investment provide investors with important signals about their actual risk tolerance and their investment portfolio’s correspondence to that. If the event of the default or a partial or full loss of investment principal, however small the original investment was, is causing frustration and thoughts of stopping the investment activities, then it would be a good reason to review the investment portfolio and the riskiness of each individual investment. This approach will have at least two tangible results:
- First, the review could confirm (and in the majority of cases, it does) that the overall investment portfolio is generally healthy and well-diversified, and the income from other investments would offset the lost capital in a short period of time. That understanding would affirm the correctness of the overall investment strategy and eliminate the emotional stress caused by the specific default event. Adding new same-risk investments to the portfolio would speed up the recovery from the occurred loss;
- Secondly, the analysis could reveal that there are several other investments in the portfolio that the investor is uncomfortable with and thus, the investment portfolio is not in line with the investor’s risk tolerance. This understanding could provide a trigger for rebalancing the investment portfolio by either selling off some or all of the “uncomfortable” investments or adding new lower-risk investments to the portfolio to outweigh the risky ones.
Read our recent article on investment risks and expected returns here!
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While the complete avoidance of risk and defaults is theoretically impossible, there are several measures that can allow investors to professionally manage their investment risks, providing for both great returns as well as good night’s sleep:
- Assessment of the risk tolerance allows for defining the overall maximum riskiness of the investment portfolio. If the idea of the loss of investment principal is completely unbearable, it would be better to limit the investments to well-collateralized, low-risk investments only;
- The evaluation and selection of individual investments ensure that the riskiness of all investments is in line with the maximum risk tolerance levels established before. If the investor’s risk tolerance is low and allows for well-secured, low-risk investments only, there should be no room for high-risk/high-expected-return investments in the portfolio (however sexy they would be). Maintaining investment discipline and a calm mind is an important part of the game;
- Diversification of investments geographically, maturity-wise, across a wide range of real estate assets and real estate companies ensures that the investments are not exposed to the same risks at the same moment in time. There is no hard evidence of the extent of diversification needed for real estate investments, but the popular sources suggest having at least 20-30 different real estate investments in the portfolio. So, when the investor’s target size of the real estate portfolio is EUR 10,000, he/she should aim to limit the individual size of each investment to a maximum of EUR 400- 500.
- There are no risk- and default-free investments;
- Default is not necessarily a tragic event resulting in a loss of investment, the majority of defaults end well with higher-than-expected final returns;
- Crowdfunding platforms and their collateral agents are highly motivated to revive or collect defaulted investments to maximize the amount returned to their investors;
- Do not use the default event to justify halting your investment activity, use the event to re-evaluate your investment strategy and overall portfolio health;
- Adjust your portfolio regularly by adding new investments (even if some of the previous ones have defaulted);
- Manage the investment risks by regularly reviewing your risk tolerance, by reviewing and evaluating the appropriateness of individual real estate investments in your portfolio and by having a large number (20+) of well-diversified investments in your portfolio.
Proceed to read our next article about the illusion of buyback guarantees.
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