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Classic: Using Investment Advice, Part 2

Posted on 9 April 2013 by David Merkel

The following was published on 3/26/2004:

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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.

Classic: Using Investment Advice, Part 1

Posted on 8 April 2013 by David Merkel

Dear Friends,

I am republishing some old pieces from my days at RealMoney during this busy time that I am in.? If there are significant changes in my opinion since it was first published, I will spell out the changes.? As for this series, there are none.

Originally published 3/24/2004

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Investment Advice

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You have to trust your investment adviser.

Look closely at the track record, too.

You want realistic advice you can use.

Advice bombards all investors. Some is good, some is bad, and much of it is indifferent. In this three-part column, I’ll show how to use the advice you receive so you can be a more effective investor. In analyzing any advice, investors have to consider the adviser, personal character issues, and the nature of the investment proposed. In Part 1 today, I’ll focus on the adviser.

Sought-After Qualities

The first issue is always one of trust: Do you trust the competence and business ethics of the adviser? No one is perfect, but has the adviser made sound decisions in the past in areas similar to where the adviser is proposing advice now? What’s the adviser’s track record? If he’s a professional, does he have a clean record with the regulators and his current and past clients?

Even if the adviser has a great track record, did he get it accidentally? In a past job, I had the fun of interviewing a large number of money managers. We had a need for a large-cap growth manager, and our manager adviser brought in a manager who had a stellar, though short, track record.

The principal of the growth manager was a former pro athlete who had developed an entirely quantitative, momentum-driven management method. The presentation was short, and I asked a few questions about earnings quality and how the process might do in nongrowth-driven markets. I received a very terse set of “we can do no wrong” answers.

After the presentation ended, I pointed out three companies in their portfolio that I knew had weak earnings quality. They politely blew me off. I wasn’t impressed with their processes, and my colleagues were not impressed with their demeanor. Then I had my accident; the next week, two of the companies I pointed out blew up. Their accident followed soon after, which was a significant loss of assets under management. The accident of their prior performance evaporated. Persistent good performance happens for the reasons that the adviser specifies in advance, not by accident.

Even if the advice giver is competent and ethical, what incentives does he have in the situation? Full disclosure allows you to decide whether the adviser’s judgment might be shaded by other concerns. Then you can take that into account in making your decision.

Is the adviser cocky? In my experience, pride goes before a fall. One way to measure this is to see whether the adviser admits to errors. The best advisers admit fallibility, and even try to reduce your expectations. You want realistic advice from someone you can trust. Big claims may draw some clients in the short run, but in the long run, clients are kept through dependability.

Next time, in Part 2, I’ll examine how your character affects how you evaluate the investment advice you get.