Taking Investment Advice from Others: Part II

The following was published on 3/26/2004:

=–==-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

 

Investment Advice

You have to understand the advice to use it.

Can you implement or monitor the idea?

Analyze your own personal motives.

 

In analyzing any advice, investors have to consider the adviser, personal character issues and the nature of the investment proposed.

Yesterday, in Part 1 of this three-part column, I focused on the adviser. Today, in Part 2, the emphasis shifts.

It’s About You

Do you understand the advice? There is no shame in not understanding every investment concept under the sun. Only rare individuals can do that. If you can’t understand what is being proposed, walk away from the idea until you can understand it. People who don’t understand an investment concept, but invest anyway, can’t react rationally to the volatility in the market, and they fall prey to fear and greed. They become the noise traders that professionals profit from.

Some strategies suffer from what I call “too smart for your own good risk.” In Britain, the phrase is “too clever by half.” This problem affects both individual and institutional investors. Some strategies are very complex, and some people are intrigued by complexity. I think most investing is simple, and complexity signifies a lack of understanding. The more complex a strategy is, the more likely it is to break down in one of its many steps. Be careful with complex strategies.

Can you implement and monitor the investment idea? Does it fit your character? I did risk arbitrage on an amateur basis for several years, but even though I did well at it, I found that the amount of time it took detracted from my family and work, so I stopped.

Some people don’t have the time, talent or personality for strategies that require rapid trading or rapid shifts in strategy. Other people don’t have the stomach for high-risk strategies, even if they understand how they work. You have to pick strategies you can sleep with.

Does the investment support your ethical standards? This applies to both the management and the business.  In general, your ability to make rational decisions in investing will be hindered if you are long a company that you think harms society. The same is true of management that you believe acts dishonestly, particularly toward shareholders. It doesn’t matter how cheap a company is: If you can’t trust the management, it will be almost impossible to unlock the value trapped there.

Also, from my personal experience, if management is dishonest to some other stakeholder group, such as customers, eventually shareholders will get bad returns. Dishonest management often has underlying business models that are unfavorable, and which they are trying to enhance unethically.

Analyze any personal motives you might have for making or not making an investment. I had a large number of usually intelligent friends who gave up their investment disciplines in late 1999 in order to buy into the bubble. Many seemed driven by envy of less capable friends who were racking up impressive profits on paper. Motives for investing that rest in uncritical admiration or dislike for another person and their prosperity usually lead to bad results.

How much of an unrealized loss could you take in the short run? Do you have the capability to carry the position through a rough period, even if the eventual result will be good? The answer depends on your liability structure. Do you need the value of the assets in question to throw off cash for you in the short run? Are you investing on margin, or have significant external debts to service? Safe is better than sorry here. At minimum, set stop orders if you can’t bear losses beyond a given threshold. It is better to avoid strategies that force you to take any action, so if you can’t take short-term losses, reduce the risk level.

Next time, in Part 3 of this three-part column, I’ll take a closer look at the nature of the investment itself.

 

By David Merkel, CFA of Aleph Blog



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.