Don’t Buy What You Don’t Understand

Risk management is a core tenet at our firm and one that we feel is often misunderstood when entering a new position. Many investors feel that the minimization of significant drawdown starts after you already own something. A common method for this practice is setting a stop loss. 

A static or trailing stop loss can help you define the amount of money you are willing to lose on any given trade. However, it doesn’t help you understand why you bought the position to begin with or what went wrong with your thesis if it is triggered. It’s simply a failsafe mechanism to stop the bleeding. (For related reading, see: Which Order to Use? Stop-Loss or Stop-Limit Orders.)

Risk management should truly begin with your due diligence process. 

The evaluation of any investment should include knowing what you own and what the primary drivers of price will be. It should also be evaluated in the context of how it will co-mingle with other positions in your portfolio. If you can’t straightforwardly answer these questions, then a particular stock or ETF probably doesn’t belong in your account at all. (For related reading, see: Where Do Investment Returns Come From?)

Put Knowledge First

Here’s a simple way summarize this point: don’t buy what you don’t understand.

The other day we gave a 45-minute seminar on strategies we are implementing for our wealth management clients. You can listen to the full audio here. 

One of the areas we talked about in the income-generating world is the potential opportunities in bank loans. The PowerShares Senior Loan Portfolio is one of the indexes we monitor for this sector.

Bank loans are somewhat of an esoteric area of the income marketplace. They don’t behave like a normal fixed-coupon bond. They require a more sophisticated knowledge of finance terminology and the understanding that price will be driven by differing factors. That doesn’t make them evil; it just makes them unique.      

Through the course of the call we were quick to point out that if you don’t understand how these things work, don’t buy them. Even if they are in a seemingly innocuous ETF format. 

The same goes for many other sectors and asset classes that are so prevalent in the ETF universe. Leveraged funds, currencies, long/short strategies, alternatives, futures-based investments, and even VIX indexes should all be assumed to offer a different risk structure than a traditional stock or bond portfolio.  Even convertible bonds and preferred stocks can behave one way given a certain set of circumstances and then completely change course. (For related reading, see: A Market Barometer: Corporate Earnings.)

Too many people become overly enthusiastic about areas of the market because of a single trait and forget to analyze the bigger picture.  How many times have you heard or thought some of these statements?

“Wow, look on at the yield on ________!”

“Can you believe how cheap _________ is?  It can’t get much better than this.”

“I’m going to buy ________.  It’s the best-performing stock/ETF/asset class this year!”

“Look at that correlation between _______ and _______.  Doesn’t get much easier than that.”

“_________ is recommending this stock, it must be good.”

“I own ___________ for the tax benefits.” (even though it’s falling like a stone)

These are just some of the ways that individual investors get into trouble. They get sold on recent performance, yield, fear, correlation, volatility, or some other notable characteristic. What they fail to fully grasp are the actual underlying securities or strategies that are used to generate those returns. 

That is where the true risk lies. (For related reading, see: Can You Stomach the Perfect Investment?)

The Bottom Line

There is no bulletproof way to vet every single investment to ensure a positive outcome. However, you can greatly enhance your odds of success by thoroughly analyzing the holdings, expenses, prospectus, historical performance, and other attributes. Taking a more skeptical approach from the outset can lead to uncovering potential red flags and avoiding areas of the market that are outside your comfort zone. (For related reading, see: Why You Should Diversify and Rebalance.)