Monday, March 23, 2015

Don’t invest in anything you don’t understand

When I would meet with prospective new clients, the main reason they said they were looking for a new financial advisor was poor performance. What I often found in these cases was that their former advisor had not done a good job of helping the client understand what they were invested in and why. As a result, I would find portfolios that didn't make sense, had high fees built in, and the client had no idea what they were invested in.

The most common example I would see would be when someone had bought a variable annuity and had no idea how it worked, why they owned it, or what benefit it provided to their overall financial plan. In these scenarios, the penalty for ending the contract early often outweighed the savings they could realize by doing so, so they were effectively stuck with a poor decision for several years. In many cases, had they understood what they were investing in and why, it is unlikely that they would have actually made the investment.

Only investing in things you understand sounds obvious, but the fact that some of the worst financial products continue to be sold is proof that it isn't. Individual investors aren't the only ones guilty of this. In the run up to the financial crisis of 2008, the city of Narvik, Norway, lost $64 million investing in synthetic CDO's, a complex product that essentially was tied to sub-prime US mortgages. A good book that talks about this in greater detail is David Fabers "And Then the Roof Caved In".
Investing in things you don't understand doesn't always end poorly, but should be avoided nonetheless. Back in early 2008, I bought shares of Visa (V) right when they first began trading. I paid around $59 per share and held them for about 6 ½ years, selling for around $260 per share, earning an average annual return of 24%. Sounds good right? The problem with this investment was that when I bought the shares, I didn't know how Visa made money! I figured it would be a good investment just because of the ubiquity of the brand name, but didn't really know what would have made the stock go up or down. Did you know that credit card companies make money every time you use your card, but aren't actually loaning you any money? This has become more common knowledge now that products like Square are allowing anyone to accept credit cards and pay swipe fees, but back in 2008, it was something I didn't yet know. This investment worked out well for me that time, but I attribute all of that to luck and not to my own understanding of the investment.

One thing I'd like to make clear though, is that although you should never invest in something you don't understand, not investing in things you don't understand is not an excuse to avoid learning about investments. Just like starting to save early will have compounding benefits in the values of your investments, the sooner and more you can learn about ways you can invest your money the better. The benefits will compound as many different investment types are interrelated and you can understand how several work by learning the basics.

To help avoid investing in something you don't fully understand, here are few questions you can ask yourself before taking the plunge.
  1. What factors will contribute to your investment going up or down in value?
  2. Are there any risks unique to this investment that wouldn't affect the overall economy?
  3. What are some comparable alternatives and how have they done? Why is this investment better than the alternatives?
  4. Who is recommending the investment and what are their incentives?
  5. What are the costs, upfront and/or recurring?
  6. How do you get money out and how long does it need to be kept in?
  7. Are there any guarantees? If so, who provides the guarantee and what exactly is guaranteed?
  8. If there is a guarantee, how often in the past XX (100?) years would I have needed the guarantee? (hint – the answer is likely close to 0, and if so, you probably don't need to pay for that guarantee).
If you can comfortably answer these questions, you're in a good spot and should have a decent grasp on what you are investing in. The idea here is not to be so knowledgeable that you can run your own mutual fund, but rather have enough of an understanding of what you're putting your money into that you are making a conscious decision of how to invest your money rather than simply doing something because someone told you to do so.

If you'd like to get a good handle of the basics, one of my favorite books for that purpose is Learn to 
Earn, by Peter Lynch. It's a book I've given to recent high school graduates or college graduates and it explains very simply how mutual funds work.

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