5 Ways to Make Sane Investments When Everyone Else Is Crazy
When grandmas and Uber drivers are boasting about profiting on Bitcoin and SPACs, don’t get sucked in to the hype. Here’s how to make sure your investments are based on reality.
The other day I received a call from a friend who wanted to know the best way to purchase a Non-Fungible Token (NFT). NFTs are one of the trendiest current investment themes. They are essentially a unit of data on blockchain that represents a unique digital item, such as digital art, audio and video files.
While it was a bit strange to receive a question about such an opaque area of the market from my friend, a social worker at an elementary school, I wasn’t overly surprised. The week before, an 80-year-old grandmother told me that she made a mint in Bitcoin, and my Uber driver told me he was considering an investment in a Special Purpose Acquisition Company (SPAC). These comments, along with the fact that every other person seems to be day trading to supplement their income, illustrate clear frothiness in the market.
Some of these investing novices are actually making a lot of money from their imprudent decisions. Their initial success and eye-popping performance may lead many to succumb to the error of “outcome bias.” The greatest concern is their being blind to the fact that they are missing one of the most important elements of successful investing, namely having a sensible process in place.
“Outcome bias” arises when a decision is based on the outcome of previous events, without regard to how the past events developed. Many novice investors may conclude that the quality of the outcome (i.e., high returns) confirms that they have a knack for picking winning investments. In many cases, this couldn’t be further from the truth. Over the short-term, one can have great returns simply by getting lucky. Conversely, one can have bad short-term returns with a good process that will still allow you to achieve your financial goals. Going through a slump with mediocre performance does not necessarily mean that your strategy is ineffective.
As the markets continue to trade near all-time highs, and as speculative investment behavior is more prevalent with the masses, it’s important to take a step back to assess your own process for making investment decisions. The considerations below can serve as a good bellwether to determine if you have a prudent strategy in place or if you are taking too much risk within your portfolio.
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.
Disclaimer: This article authored by Jonathan Shenkman a financial adviser at Oppenheimer & Co. Inc. The information set forth herein has been derived from sources believed to be reliable and does not purport to be a complete analysis of market segments discussed. Opinions expressed herein are subject to change without notice. Oppenheimer & Co. Inc. does not provide legal or tax advice. Opinions expressed are not intended to be a forecast of future events, a guarantee of future results, and investment advice. Dollar-cost averaging does not guarantee a profit and does not protect against loss in declining markets. Investors should consider their ability to continue making purchases through periods of fluctuating prices. Global diversification does not guarantee a profit nor protect against a loss. Adtrax #: 3556073.1
About the Author
Associate Director - Investments, Oppenheimer and Co. Inc.
Jonathan Shenkman is a financial adviser, portfolio manager and the founder of the Shenkman Private Client Group of Oppenheimer & Co. Inc. He is experienced in developing creative strategies that allow his clients to achieve their retirement, estate and philanthropic objectives.