5 Ways to Make Sane Investments When Everyone Else Is Crazy
The other day I got a call from a friend who wanted to know the best way to buy a non-fungible token (NFT). NFTs are one of the hottest investment themes. They are essentially a unit of data on the blockchain that represents a unique digital element, e.g. B. digital art, audio, and video files.
While it was a bit strange to get a question from my friend, an elementary school social worker, about such an opaque area of the market, I wasn't particularly surprised. The week before, an 80-year-old grandmother told me that she had made a mint in Bitcoin, and my Uber driver told me he was considering investing in a Special Purpose Acquisition Company (SPAC). These comments, as well as the fact that every other person appears to be doing day-to-day business to supplement their income, illustrate a significant amount of foam in the market.
Some of these newcomers to investing actually make big bucks from making ill-considered decisions. Their initial success and impressive performance can lead many to succumb to the "bias" mistake. The biggest concern is that they are blind to the fact that they are missing one of the most important elements of a successful investment, which is a sound process.
Outcome bias occurs when a decision is based on the outcome of previous events, regardless of how past events developed. Many inexperienced investors may conclude that the quality of the result (ie high returns) confirms that they have a knack for choosing profitable investments. In many cases, this couldn't be further from the truth. In the short term, you can get big returns simply by being lucky. Conversely, a good process that allows you to continue to meet your financial goals can produce poor returns in the short term. A slump with mediocre performance doesn't necessarily mean your strategy is ineffective.
With markets continuing to trade near all-time highs and speculative investment behavior becoming more prevalent among the masses, it is important to take a step back in order to evaluate your own investment decision making process. The following considerations can serve as a guide to whether you are pursuing a prudent strategy or whether you are assuming too high a risk in 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 with the lemonade stand she's about to open this summer. I told her that to grow her business, she may need to borrow money or hire partners to fund her lemonade stand. She told me that she didn't want partners or pay anyone money. While this may limit her growth potential, she now has a basic understanding of the differences between stocks and bonds. I had no problem explaining these concepts to her in plain English because I understand her. I found it harder to explain NFTs to an adult, mainly because I don't fully understand how they work or what the investment thesis is behind them.
One of the biggest mistakes people make when investing is grabbing opportunities they don't understand. If your friends and co-workers do it, it must make sense, right? Not correct! Take the time to understand how investing works and how you can make money.
Charlie Munger, Warren Buffett's partner at Berkshire Hathaway, is known for his three-box investment approach: "In", "Out" and "Too Hard". His "Too Hard" box is the largest. If other investors said “I don't understand” more frequently and moved on to another opportunity, they would minimize their investment errors 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, it makes sense to take a small position to minimize large losses. If, when you review your holdings, you find that a position represents more than 10% of your total portfolio, you should cut this investment if possible.
Overconcentration is especially prevalent today, given the surge in the market, especially in soaring tech stocks and some cryptocurrencies that have risen exponentially in recent years. It is important to remember that making a profit is generally not a bad decision. While there is always an opportunity to make more money as that investment continues to appreciate in value, if the position crumbles and wipes out a significant portion of your net worth, the pain is far worse.
3. Do you have good discipline about when to sell?
Most investors can point out the reasons why they decided to buy a particular investment. However, few people have a framework for when to sell.
The uncontrolled growth of a position can put too much capital at risk for an investor. For this reason, it is important to establish criteria for selling an investment. The displays may differ depending on the product. For example:
- Selling strategies for hedge funds or mutual funds can be triggered by style drift, in which the portfolio manager invests outside of his predetermined parameters.
- A stock can be worth selling after it hits a certain price or when the management team changes.
- Alternative assets may be worth cutting back after a certain holding period if they make up more than a set percentage of your portfolio or if the business cycle shifts and the investment thesis is no longer relevant.
The key is to understand your appropriate sales triggers and implement them as needed.
4. Do you need the money to invest soon?
One of the most important factors in managing capital is understanding the investor's time horizon when they will need their money back. It sounds simple, but very often this concept can get lost in the euphoria of a bull market.
When reviewing your investments, it should be done with the ending in mind. If you need your cash short term to pay a down payment on a home, avoid investing in venture capital or growth stocks. However, if you have a time horizon of several decades, you may want to invest a portion of your portfolio in volatile, small cap growth stocks that may value more than the market as a whole. Additionally, it may be wise to invest in illiquid private equity strategies to take advantage of the illiquidity premium that compensates for not needing your money for decades. An investor's liquidity needs are essential when determining an investment strategy.
5. Is your money treated transparently?
Do you understand what happens to each of your investments? Or do you work in a black box? Some of the biggest mistakes people make with their money is giving it to someone who promises to have access to great opportunities and great returns without explaining how it can be achieved. Note that the initial success of most scam or ponzi programs throughout history can usually indicate a lack of transparency.
Investors should have easy access to information about and the employees of the organization that manages their capital. If any of these points are not available, take your capital elsewhere. It's an easy way to bypass potential financial gimmicks.
When it comes to establishing an adequate process for managing wealth, the ultimate rule of thumb - and a common denominator of all of the above - is to pass boredom over excitement. Contrary to what may be popular today, the level of amusement experienced with successful investing should be more like drying paint than a day at the racetrack. If you're checking price fluctuations on your phone every minute, feeling the urge to double a loss in stocks, or want to use your rental money to build a winning position, then gamble, don't invest. A boring process will help keep investors out of trouble while keeping compound interest going for many years. This boring process is the surest way to achieve long-term financial success. And that's pretty exciting.
Disclaimer: This article was written by Jonathan Shenkman, a financial advisor at Oppenheimer & Co. Inc. The information contained herein has been obtained from sources believed to be reliable and does not purport to be a complete analysis of the market segments discussed. The opinions expressed here are subject to change without notice. Oppenheimer & Co. Inc. does not provide legal or tax advice. The opinions expressed are not intended as a forecast of future events, a guarantee of future results, or investment advice. Averaging the dollar cost does not guarantee profit and does not protect against losses in declining markets. Investors should consider whether they can continue to make purchases during times of fluctuating prices. Global diversification neither guarantees a profit nor protects it from a loss. Adtrax #: 3556073.1
This article is written by our contributing advisor and presents the views of our contributing advisor, not the Kiplinger editorial team. You can review advisor records with the SEC or FINRA.Associate Director - Investments, Oppenheimer and Co. Inc.
Jonathan Shenkman is a financial advisor, portfolio manager and founder of the Shenkman Private Client Group of Oppenheimer & Co. Inc. He has experience developing creative strategies that enable clients to meet their age, estate and philanthropic goals.
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