Investment and Risk

To invest or not to invest? That is the question all investors and potential investors should ask themselves. One of the paradoxes of economics is that one of its most basic tenets-there is no free lunch-is not widely understood or even believed by the majority of people. Do you understand that a free lunch cannot possibly exist in this universe, in the same manner that Santa Claus, the Easter Bunny, the Tooth Fairy, and the Great Pumpkin cannot exist? If your mother makes you a peanut butter and jelly sandwich with a glass of milk and some cookies, she does it because she loves you, not because she is hell-bent on insidiously abrogating an immutable law of economics. If you intuitively understand that if you are presented with a lunch that didn’t cost you anything, that means that someone, somewhere had to buy or work for that lunch, then by all means, invest to your heart’s content. But if you don’t implicitly understand this fundamental principle, do not even consider investing your money-do not pass Go, and do not collect $200. Spend your money or keep it in the bank, rather than invest it.

I bring up this point to underscore that a large part of our economy is devoted to and dependent on people who do not only not understand this most basic precept, but who fervently and devoutly hope beyond reason, with every fiber of their beings, that a free lunch can and must exist somewhere, somehow in this universe, or that their lives simply aren’t worth living. And if you go into investing believing that a free lunch is not only desirable and tempting but even fundamentally possible, be forewarned that there are legions of people armed to the teeth with all manner of devices who will try to exploit that very belief to their own benefit, at the expense of your own.

Closely allied to the no-free-lunch idea is the risk=reward relationship. An investment that is spectacularly rewarding is also equally risky-it must be, because if it weren’t, everyone would be investing in it and, in the ensuing rush of capital, all markets would close down in a matter of days and financial life as we know it would grind to a halt. Conversely, any relatively safe investment isn’t going to be spectacularly rewarding, for essentially the same reason. If this makes sense to you and you implicitly understand it, then investing may be for you. If it doesn’t, then investing is in no way, shape or form right for you.

Why do people invest anyway? After working at a financial publisher for over five years and speaking with all kinds of investors, I found two common motivations, besides the Las Vegas mindset that gambling was somehow entertaining-the overall feeling that a party was going on somewhere and they were missing it, as in someone reading about someone else making some spectacular returns on a particular investment, followed by the inevitable unanswerable question of Why can’t that be me?, and the corrosive feeling that every day inflation was eating away their principal, every day leaving them one day closer to their ultimate horror-the specter of having to face going back to work at an everyday job.

Most of us have heard the siren song of the stock market averaging over the long haul ten or eleven percent a year return, but a statistic heard far less often is the market share proportion of large institutional investors-55%-to small individual investors-45%. This does not mean it is impossible for a small individual investor to make money in the stock market-but it does mean that small individual investors are behind the eight ball before they even get started. Large institutional investors such as the Harvard endowment or Carnegie-Mellon have the home field advantage in every way except one-they are paid to play. Small individual investors can choose not to invest at all if they desire-not so with large institutional investors. If you understand this, then invest away-but if you don’t, run far, far away from investing and never look back.

Another common mistake is for investors to invest in something they don’t understand. At my old job with the financial publisher, I would try to explain short selling to some people over and over-and some people still wouldn’t get it. If you don’t understand short selling or any other exotic investments, such as options, futures, closed-end mutual funds, or penny stocks, then these are emphatically not the investments for you. Penny stocks, for example, are tempting to many beginning investors because their price per share is so low. But many of these companies are fraudulent and don’t even exist, or otherwise are easily manipulated because they are so thinly traded. If you can turn around and explain how you would or wouldn’t make money with any particular investment to your grandmother or a sixth-grader, this could be an investment for you. If you can’t, then you need to keep looking for a different investment.

All financial markets are constantly being discounted by professionals who are constantly testing the waters, throwing bait out there to see who bites what and who doesn’t. These people will make money regardless of what kind of market there is. But the unsaid part of that is that the most money is made when the broader markets are headed up or headed down, and for the last seven years, with some notable exceptions, the broader markets have been doing neither, what’s called moving sideways, where everyone makes the least money. If you understand that all the major indexes-Dow-Jones industrial average, S & P 500, the NASDAQ, et cetera-are all roughly where they’ve been for the last seven years and you’re comfortable with that, then by all means invest. But if that gives you pause or you don’t understand the dynamics behind that, then do not invest at all.

In studying for the Series 7 test on my own and the classes we had at my old job where we learned technical analysis, charts and graphs, trends and Japanese candlesticks, I came away with an even more basic lesson, that there are two different kinds of learning-the hard way from your own mistakes, or the easy way from other people’s mistakes. If you paper trade with a mock portfolio for any length of time, you should be able to gauge whether any market swings are going make you unduly ill or lose any sleep. Worrying about your money to the point of it making you sick negates the last great myth-that money makes you happy.

Author’s note: Since I wrote this over two years ago, obviously much has happened in the world financial markets. Based on the trends in the technical analysis I did on a few spot-checks of some of the recommendations we made when I was at Weiss, it appears that the washout was in late March of this year (2009-to see this yourself, simply go to www.bigcharts.comand run a few of your favorites-I used DIS, ERF and IBM, just for fun.) With the Dow Industrials average flirting with 10,000, some people might see this as good news. But be forewarned-residential real estate foreclosures are at an all-time high and because of this, banks are forestalling their usual foreclosing proceedings simply because the sheer amount is so great. Until all these foreclosures work their way through the system, we can’t set a floor on real estate prices and until that’s established, we can’t accurately value these mortgage-based collateralized instruments and their derivatives that got all these lending institutions into hot water in the first place. Add to that record numbers of banks failing because they made all these loans that are now being defaulted on, this becomes a vicious cycle with no clear end in sight. Based on the theory of sector leadership, the same way real estate and banks dragged down the larger markets, so also must some sector or sectors lead the way back up. If this recovery is on a shaky foundation, the more unstable it will become if something-such as another 9/11 or natural disaster-comes along to jar it.