Buying The Next Hot Idea

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Photo Credit: Nart Elbrus

If you want to know what is the core problem of the average person approaching the market (though this applies more to males than females, women have more native caution on average), it is chasing a hot idea. This can take a number of forms:

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  • Getting tips from friends who have bought some stock that is currently popular in the market.
  • Doing the same thing with investors who talk or write about investing. The best investment advice is not flashy, and does not make for good video.
  • Looking at charts and buying something that is rising rapidly, because popular media say this is “The Next Big Thing.”
  • Buying the mutual fund or other pooled vehicle of some manager who has done very well in the past, and seems to never fail. (If you buy a mutual fund, don’t buy one that has had a lot of money pile into it recently… usually a bad sign. Spend more time to see if the manager thinks in a businesslike way about assets that he buys.)
  • Going to a broker who is very well-dressed and confident, and talks really well, but who has no obligation to act in your best interests. If you don’t know how he is earning his money from you, avoid him, because it usually means investments with high fees or hidden ways that you can lose, e.g. structured notes that offer a nice yield, but where possibilities to lose are more significant than you think. At best, he will give you consensus ideas and managers that deliver him above average remuneration.
  • Buying the newsletter of some overly confident person who claims to know the secrets of the market, which he will share with you and 100,000 other close friends for a mere $299/year! (Please read Mark Hulbert before buying a newsletter.)
  • Worse yet, giving into the fakery of those who try to bring you into a hidden opportunity. It can be a Ponzi scheme, a promoted stock, but they suggest returns that are huge… or, like Madoff, decent but not exorbitant returns that are altogether too regular.

Many of these appeal to our desire to get something for nothing, which is endemic — we all have it to some degree, and marketers play off this regularly by offering us “free” this, and “free” that. Earning returns from your investable assets is a business in its own right, and there are costs to doing it well. You should not be surprised that doing well with it will take some time and effort.

You also have to avoid the impulse that there is some hidden knowledge, or group of insiders that have found an easy road to riches. The markets aren’t rigged in any material way. The principles of investing are well-known, but applying them takes creativity, time and effort. There are no significant players with a new theory who make amazing money investing in secondary markets for stocks and bonds.

Most of the things that I listed above involve low-thought imitation of others. There is little advantage in investing to mimicry. Even if it worked for someone else, the prices are different now, and easy gains have been made. You will do worse than the one you are trying to imitate with virtual certainty, and likely worse than average. You need to plan to take an independent course, and learn enough such that if you do choose to use advice of any sort, that you can evaluate it rationally. If you choose to do it yourself, you will need to learn more than that. It takes effort, but that effort will pay off, if not in investing itself, but there are spillover effects in intelligent management of your finances, and in improving your abilities in the businesses that you serve.

In most areas of life, most things that pay off well take effort. If people present you with easy or hidden ways to make above average money, be skeptical. Doing it right takes discipline and effort. (If you want the easy route while avoiding all the pitfalls see the postscript. It is boring, but it works.)

Postscript

As an aside — you can always index, and beat most average investors over the long haul. Buy broad funds that invest in a large fraction of all of the stocks that there are, and those that replicate the bond market as a whole. Make sure they have low fees. Buy them, hold them, and be done. You will still face one hurdle: will you be able to maintain your strategy when everything is in a crisis, or when your friends tell you they are earning a lot more than you, and it is easy to do it? Size the bond portion of your assets to the level where you can sleep soundly in all circumstances, and you will be fine.

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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.