Difficult problems can sometimes best be solved by inverting them. In the spirit of Carl Jacobi (via Charlie Munger), this post will approach investing by listing what not to do. After all, the first goal should be to do no harm to your portfolio and your financial future.
A great guide in what to avoid is Josh Brown, the Reformed Broker. His writings are referenced liberally in what follows, and his book Backstage Wall Street is must reading to avoid being prey for the con artists and charlatans of the financial world.
Avoid Unnecessary Complexity
Complex financial products and strategies should be avoided, unless you have mastered all of the nuances thereof. Even then, simplicity is usually your friend. Complexity in finance is usually the tool of the pickpocket — think Bernie Madoff and morally ambiguous brokers.
We all would love to think we have found a risk-free way to make 20% annual returns, and many unscrupulous operators will promise you they have found the Holy Grail. Your radar should start pinging if they push a product or strategy with impressive-sounding jargon and impenetrable gobbledygook, whisper of its exclusivity and how lucky you are to be let in on it, or promise high returns with no risk. Just like the magic pill where you can eat all you want and lose weight, this doesn’t exist.
Although we can live in hope that science and technology may one day invent the magic diet pill, high investing returns with no risk will never exist. As Josh points out, “The only reason investing works is because things can go wrong.”
Avoid Private Placements
A crucial category to avoid is any private placement being pushed by a broker. A private placement is not traded on a public exchange. Prime examples to avoid are non-traded REITs and private limited partnerships. Many times the broker pushing these bombs will even use the fact they are non-traded as a selling point, as in, “It’s non-traded, so there is no volatility.”
Josh has done a great service by pointing out these and other murder holes as “investments” to be avoided at all costs. In his words, “Almost every private placement you have ever been pitched or will ever be pitched is a scam.”
Using leverage is a really good way to reduce the likelihood your portfolio will succeed in meeting your long-term goals. Infinite examples exist, but my favorite is the tale of Long-Term Capital Management, a hedge fund run by a bunch of Nobel Prize winning Ph.D.’s. They nearly collapsed the financial system when their leveraged bets behaved in ways their models told them were virtual impossibilities.
As the apocryphal Keynes’ aphorism goes: The market can remain irrational longer than you can remain solvent.
Leveraged and Inverse ETFs are especially to be avoided, as they are intended for daytraders, and are reset daily. These are not to be held long-term, as they will almost surely eventually eat up the lion’s share of your capital.
Theoretically, money can be made in options with less upfront capital required. What this basically means is that there is inherently high leverage in options. This alone would make me take a pass.
But in addition to the leverage, options add the “feature” of time decay. In other words, you not only have to be right on intrinsic value and your investment thesis, but you have to be spot on in terms of timing. Otherwise your option expires worthless. This isn’t investing, it is speculation.
Only a small fraction of people can do the math and manage their risk in such a manner as to not blow up in this arena. Most of them are probably working at hedge funds, high-frequency trading firms, or doing theoretical physics. If you think you have an edge competing against these people with these constraints, then good luck. As Warren Buffett has said, “If you are at a poker table and can’t figure out who the patsy is, it’s you.”
As for me, investing without the curses of leverage and time decay is complicated enough. If you still want to play with options, then I have a lovely piece of property in Indonesia to sell you.
Avoid Exotic New Products
In this category would go structured notes and liquid alts. Structured notes are a new and opaque way to promise the moon for free while charging high fees and hiding risks from the buyer. Liquid alts are piggy-backing on whatever is new and hot such as long-short hedge funds or or Ray Dalio-esque risk parity type strategies. Both of these are the triumph of marketing over investing sense.
In addition to these legitimate but unneeded innovations, there are also all sorts of frauds out there using exotic supposed “securities.” As one example, I’ve heard of promissory note frauds which have snared a lot of people.
There are a lot of affinity frauds where charismatic sociopaths prey on members of their own church or other social group. Many examples of these and other frauds can be seen on the CNBC series American Greed. This is one program on CNBC that is actually likely to benefit investors. Caveat emptor people.
Avoid Penny Stocks
Another area of mischief is penny stocks. Sometimes referred to as trading in the Pink Sheets, fraud and manipulation is the backbone of this area of the market. Very rarely a real successful company will emerge from here, but this is about as rare as winning the lottery.
This was the home of the fraudulent IPO pump-and-dump schemes of Jordan Belfort, whose story is featured in the movie The Wolf of Wall Street.
A current example of fraud in penny stocks is Cynk Technology. The price of CYNK was up 24,000% or so in a month before regulators started asking questions about the supposed social-networking site that has no revenues and only 1 employee.
Avoid High Costs, High Turnover, and Tax Inefficiency
High cost products and strategies are the bane of good investment performance. Jack Bogle has been huge in noting this and helping individual investors avoid the high-cost trap. His Cost-Matters Hypothesis was revolutionary when he started the Vanguard S&P 500 Index fund, but has since become accepted wisdom.
High turnover is also to be avoided because the increased trading costs and resulting tax inefficiency can add up to a double whammy against your portfolio. Tax inefficiency applies if the high turnover takes place in a taxable account. As Charlie Munger has said, the difference over long time periods can be “truly eye-opening.”
Keep any high turnover activity in a tax-favored account like an IRA or 401(k). As Michael Batnick points out, even the greatest trader in the world can’t beat an index fund after tax in a taxable account.