5 Ways to Make Sane Investments When Everyone Else Is Crazy

1. Can you explain your investments to a child?

The other day I explained the difference between stocks and bonds to my 5-year-old daughter using an analogy to the lemonade stand she plans to open this summer. I told her that for her business to grow she may need to borrow money or take on partners to infuse her lemonade stand with capital. She told me that she didn’t want partners or to pay anybody money. While that may limit her growth potential, she now has a basic understanding of the distinctions between stocks and bonds. I had no trouble explaining these concepts to her in simple English because I understand them. I had a more difficult time trying to explain NFTs to an adult, mainly because I don’t fully understand how they work or the investment thesis behind them.

One of the biggest mistakes people make when investing is rushing into opportunities that they don’t understand. If their friends and colleagues are doing it, then it must make sense, right? Wrong! Take your time to understand how the investment functions and how you can expect to make money.

Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway, is famous for having an investing approach with three boxes: “In,” “Out” and “Too Hard.” His “Too Hard” box is the largest. If other investors more frequently said “I don’t understand” and moved on to another opportunity, they would minimize their investment mistakes and be more inclined to stick with sensible investments during rough market cycles.

2. Is your portfolio at risk of overconcentration?

The opposite of prudent diversification is overconcentration. When entering a new investment, taking a small position to minimize large losses is sensible. When reviewing your holdings, if you notice that any one position accounts for more than 10% of your overall portfolio, then it’s worth considering trimming that investment, if possible.

Overconcentration is especially rampant today, given the run-up in the market, particularly with high-flying tech stocks and some cryptocurrencies that have gone up exponentially over the past several years. It’s important to remember that it is generally not a bad decision to lock in gains. While there is always the possibility of making more money if that investment continues to appreciate, the pain if the position craters and wipes out a meaningful portion of your net worth is much worse.

3. Do you have a good discipline about when to sell?

Most investors can point to the rationale of why they decided to buy a particular investment. However, few people have a framework for when they should sell.

Allowing a position to grow unchecked can put too much of an investor’s capital at risk. That’s why it’s important to establish criteria for when to sell an investment. The gauges may differ by product. For example:

• Selling strategies for hedge funds or mutual funds may be triggered by style drift, where the portfolio manager is investing outside his predetermined parameters.
• A stock may be worth selling after it hits a certain price or when the management team changes.
• Alternative assets may be worth trimming after a particular holding period, when they account for more than a set percentage of your portfolio, or the economic cycle shifts and the investment thesis is no longer relevant.

The key is understanding your appropriate sell triggers and implementing them as needed.

4. Do you need the money you’re investing anytime soon?

One of the most important factors in managing capital is understanding the investor’s time horizon for when they will need their money back. It sounds basic, but very often this concept can get lost in the euphoria of a bull market.

When reviewing your investments, do so with the end in mind. If you need your money in the near term to make a down payment on a house, then investing in venture capital or growth stocks should be avoided. On the other hand, if you have a multi-decade time horizon, you may wish to invest a portion of your portfolio in volatile small-capitalization growth stocks that may appreciate more than the overall market. Furthermore, investing in illiquid private equity strategies may be prudent to take advantage of the illiquidity premium that compensates for not needing your money for many decades. An investor’s liquidity requirements are essential to determine any investment strategy.

5. Is your money being handled with transparency?

Do you understand what is happening with each of your investments? Or do they operate within a black box? Some of the biggest mistakes people make with their money are giving it to someone who promises access to great opportunities and great returns without an explanation of how this will be achieved. Be mindful that throughout history the initial success of most fraud or Ponzi schemes can typically point back to a lack of transparency.

Investors should have easy access to information about, and the people at, the organization that is managing their capital. If either of these items is not forthcoming, take your capital elsewhere. It’s an easy way to sidestep any possible financial shenanigans.

When it comes to establishing a proper process for managing wealth, the ultimate rule of thumb — and a common denominator of all the aforementioned items — is to embrace boring over exciting. Contrary to what may be popular today, the level of exhilaration experienced with successful investing should more closely resemble watching paint dry than a day at the racetrack. If you are checking price fluctuations every minute on your phone, have the urge to double down on a losing stock, or want to use your rent money to add to a winning position, then you are gambling and not investing. A boring process will help keep investors out of trouble and simultaneously let compound interest work its magic over many years. This dull process is the surest way to achieve long-term financial success. And that is quite exciting.