Too Much Complexity, Not Enough Common Sense

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Investment portfolios have gone so far beyond any type of logical reasoning that it is time we take a step back and look at the fundamentals of investing. What we are currently doing is just not working and could have some grave consequences down the road. Lets stop and think about what we are invested in and what our investing goals are.

Before the crash of 2008 there were so many complex investment vehicles that nobody really knew what they had. This has not changed. Human judgment was taken off the table and in reality nobody knew who owned the true collateral of the underlay paper that was being passed around. Yet all the risk models and risk gurus in the industry were stamping triple A credit ratings on these vehicles without knowing what the ultimate risk was. To make matters worse they would add layers of protections and regulations to make you feel more secure thus compounding the crises rather than extinguishing it. It is ludicrous! The complexity of the machine was beyond any ones capability to understand and handle. It was nothing but paper, with some legal jargon, being traded. This paper needed to be gobbled up by investors to produce more money and more paper for other investors. They moment they quite feeding the machine is the money the game ends. The quicker it all happened the more money everyone would make along the line starting with the originators and ending with the big pension funds. I guess you could say we were all a bit crazy and didn’t really step back and figure out what we were truly buying. Investing is perilous enough when investing in simple stocks and bonds, but is has become downright dangerous with the complexity of the current financial products.

Jump forward to 2011. Have we learned our lesson? Have things changed? If I were to ask you what you are invested in, would you be able to explain it to me? Probably not! Nothing has changed it has become more complicated because of the new regulations put on these products by the government. Wall Street is still pushing paper investing in complex instruments that nobody knows how to dissect. It is so far beyond complicated lets just say that banks and investment firms like to create any type of paper (derivative) as longs as they can sell it at a premium. Here is a simple example I found

“Bankers Trust marketed a low-cost derivative contract to hedge interest rate risk, but nobody seemed to realize that the low cost masked a feature that would turbocharge losses if rates suddenly shot up, Procter & Gamble learned about this the hard way losing $150 million.” It is not uncommon for Young traders to engage in huge derivative cross-trading causing banks to collapse within a couple of years. Examples like these are happening on a daily basis.

“When the foreign exchange desk at Salomon Brothers wrote put options in a bet that the yen had peaked, no one noticed that the nonlinear feature of the put options magnified the loss nearly fifty fold when the yen move 10 points higher rather than just one or two points.” (A Demon of Our own Design)

If we look back, we can see the problems and point fingers but hindsight is always 20/20. My question is, if all this complexity causes so many problems then why do we continue to do the same exact thing and invest in the same products? With these complicated products we can not prepare or understand the causalities that lie ahead of us. Lets return to the basics of investing by reducing the complexity of our portfolios. There is nothing more dangerous than taking risks when you have no idea you are taking them. It is the Iceberg beneath the water that can ruin the whole ship. Does the titanic ring a bell?
The Fundamentals of Investing

1. If you do not understand it do not invest in it.

The more complicated the product, the less transparent the risks. This happened with the sub-prime meltdown in 2008 nobody really new what kind of risks they were taking on nor did they understand the fees they were paying to purchase MBS, ABS, CMO, and CDO. If the agencies barley understood the products they were selling what make us think we can. KISS (keep it simple stupid)

2. Risk is part of investing there is no such thing as a “risk free return”

You can never end up with a risk free investment. If I am being sold on some type of investment product and the words “risk free” come out of the salesman mouth I turn and run the other way. You can never end up as safe as you think because there are so may factors out there that can ruin any great investment. When you learn to accept that risk is a part of investing then and only then are capable of making better decision. You will learn to protect your capital and diversify it among many different asset classes. In life disasters happen all the time so why would we not expect a disaster to happen with our investments.

The higher the return the higher the risk! When you invest you should ask what is the overall return that the investment is producing. Two years ago I looked at purchasing Ginnie Mae government backed Mortgage-backed securities. I was told that my money was 100% protected by the government and they also was giving me a 3% monthly return on my money. When I looked into the product I found out that the company was actually making a 6% monthly return on the investment. What does that tell me? If I can get a 6% monthly return I am taking on a lot higher risk then the 3% monthly return that I am being paid. Do all you can to find out what the actual investment pays not what you are making. That way you will be able to accept the risk and allocate the right amount of capital towards that investment. Instead of putting 25% of your portfolio you may want to put 5%.

3. Buy low sell high

Buy your stock, bonds, currencies, real estate, and commodities at a low price and sell it at a high price. Do not chase the price of any investment there are always good deals out there.

4. Supply and Demand

True products operate on the laws of supply and demand on occasion there is irrational behavior to the upside and downside but if something has a large demand with a small supply it will go up in price.

5. Randomness plagues all markets. Markets are irrational and should not be trusted

The more investors win the smarter they think they are thus adhering more strongly to their views. They can do nothing wrong and the market continues to confirm their brilliance. More money enters into the markets pushing egos even further until they the “wise” investors dump their positions to the “smart” ones. It is nothing but a game and should be treated as such our greatest competition is ourselves. The best example of this is Tulip Mania that happened back in the 1630s in Dutch. It is a great read and applies to us today. Often times we will look back and wonder why the Dutch were so crazy, but I think if they saw what we have been up to for the last 5 years we would be considered insane not just crazy. When bubbles burst the inescapable fact is our emotions got the best of us and the thing we traded really doesn’t have much value.

6. Keep it Simple Stupid (KISS)

Even Leonardo Da Vinci said “simplicity is the ultimate sophistication.” Why is it that we always want to complicate things. Here is what they found from a simply study on keeping things simple.

“Make it simple and people won’t buy. Given a choice, they will take the item that does more. Features win over simplicity, even when people realize that it is accompanied by more complexity. You do it too, I bet. Haven’t you ever compared two products side by side, comparing the features of each, preferring the one that did more? Why shame on you, you are behaving, well, behaving like a normal person.”

We are drawn to complexity and for some reason we think the more complex the better it is. This is not the case, this is just another example of our emotions and greed getting the best of us.

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