There's an interesting term in the financial world: "qualified investor." I bet it doesn't mean what you think it means.
A qualified investor, sometimes referred to as an "accredited investor," is someone deemed to have sufficient financial sophistication to be excluded from certain U.S. regulations that are designed to protect most investors. For example, companies that wish to raise capital from individuals without issuing registered securities must limit their search to accredited investors. The general public is thus excluded from investing opportunities such as privately held companies and hedge funds, which can be particularly risky.
Stemming from the Securities Act of 1933 and defined in Regulation D, accredited/qualified investors are classified as meeting certain criteria, such as having an annual income of at least $200,000 in each of the past two years ($300,000 for joint income) or a net worth of at least $1 million. There are other criteria and restrictions, too; for example, the net worth may be held jointly with a spouse and may not include a home's value in the calculation.
Measures of sophistication
The reasoning here is that it would be dangerous to let unsophisticated investors participate in less regulated (and often riskier) investments. The investors should know what they're doing. That certainly seems like a fine idea. It seems a bit questionable, though, that sophistication is measured by wealth.
We've surely witnessed enough wealthy people make stupid financial moves. (Think of the Nobel-winning economists and Wall Streeters whose hedge fund Long-Term Capital Management collapsed in 1998, nearly triggering a global financial crisis.) And we've also seen people who start out with next to nothing and do terrifically well for themselves. These people may have been qualified to invest, though they didn't meet the criteria above.
Most of us aren't looking to make such investments, though. For most of us, the stock market is all we need to build long-term wealth. So how might we better define "qualified investor" for the purposes of determining who should invest in the stock market? Here are some possibilities.
A qualified investor should:
- Not be saddled with loads of high-interest debt, such as from credit cards.
- Have the time and interest to study investing and get better and better at it.
- Know what to expect and know how the stock market has performed, on average, over the long haul. (Over the past century, the average annual return has been about 10%.)
- Have a long time horizon (at least five years, and ideally 10 or more) and be prepared to be patient.
- Understand terms such as "margin of safety," "intrinsic value," "market capitalization," "return on equity," "gross profit margin," and other common financial lingo.
- Be prepared to keep up with each of his or her holdings, ideally at least quarterly. This means reading annual and quarterly reports and news stories.
Our "13 Steps to Investing Foolishly" offers more insight into what is needed to be successful in stocks.
If you're not qualified
If you can't meet all the criteria above, or if you just find studying stocks to be boring, that's OK. You can still do quite well with stocks by sticking to a simple and inexpensive index fund, such as the Vanguard 500 Index (VFINX) or the SPDR S&P 500 ETF (NYSEMKT:SPY). Plunk your money into such an investment, and you'll instantly be diversified across 500 companies. Your returns will closely track the overall return of the S&P 500 and even the entire U.S. stock market. Not bad, eh?
By investing with broad-market index funds, you'll likely beat the performance of the majority of managed mutual funds, as those tend to charge significant return-reducing fees. And according to the S&P Dow Jones Indices SPIVA scorecard, about 70% of U.S. stock funds underperformed their benchmark indexes over the past five years -- so you'll likely beat many "qualified" investors, too!
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.