Values Added

Risk Factors

I was recently interviewed by Emily Stewart (Vox) for The stock market can be an emotional roller coaster. It shouldn’t be.

She asked about the emotions surrounding investments, trying to outsmart the market, risky investments, who they make sense for, and for some broader reflections. It’s well worth a read!

People often ask us if they should invest in specific high-volatility investments, like a friend’s new business, various crypto currencies, a startup, etc. The right answer will depend on the circumstances. But it can still be helpful to know some of the factors to consider before making a high-risk investment. Here’s my high-risk investment “checklist” or “score card”.

Questions To Ask Before Investing

Investments with high upsides, the sort that might lead us to dream big, also tend to have a greater chance to lose money due to greater volatility. For most people who need the money soon, it’s a bad idea to invest in something where there is a decent chance of losing money.

Everybody’s situation is different but as you think about investment in what you hope will be the next big thing (but might be a debacle), here are a few reflections you might consider:

  • Can you afford to lose the money?
  • The more fun/exciting the investment is, the more skeptical you should be
  • Read A Short History of Financial Euphoria
  • Are you smart? If so, that’s a risk factor too.
  • Do you understand it?

Can you afford to lose the money?

So, should you invest in a volatile investment like cryptocurrency, a private business, or a small company? For someone who doesn’t have a stable financial foundation the answer is usually no. If you don’t have things like an adequate emergency fund, properly-funded retirement accounts, college savings for any kids who are likely to attend college, adequate insurance, and so forth, then you don’t have much capacity to take on risk.

If you have a long-term plan that is on track, and the money you are considering investing is not required for that plan, you can afford to lose the money. And finally, even if you have the capacity to take on risky investments, you still want to be sure the investment is likely to be profitable enough to justify the increased risk.

Beware of fun!

Mary Oliver famously challenged each of us as to what we would do “with your one wild and precious life”. Of course, for most people, having fun and doing exciting things is part of how we spend our precious little time here. So “Avoid Fun!” is very strange advice. And yet, investing isn’t meant to be fun. If you are having fun with it, that’s a warning sign that things could go wrong.

Why is that?

When investments are fun, more people want to participate. When more people participate, the terms tend to become less beneficial to investors. And that’s if it really is a proper investment at all.

When investments are fun, people have a tendency to get caught up in the excitement and reduce their skepticism.

Investment should usually be boring–that’s an indication you are doing it right. Are all boring investments good? Of course not. Just as not all exciting investments are bad. But if you feel excitement about a specific investment, notice that feeling and increase your skepticism to match.

A Short History of Financial Euphoria

We so often assume that a situation we are in is novel. Cryptocurrency seems so unprecedented! And yet, there have been speculative bubbles for centuries. John Kenneth Galbraith, a giant of 20th century economics and politics, was one of the first to study this area, reviewing centuries worth of bubbles to trace patterns and understand them better. His history begins with an amazing example, the Dutch Tulip Mania in the 17th century. During the bubble’s peak, in 1637, some single tulip bulbs sold for more than 10x the annual income of a skilled artisan. Looking back at historical examples and seeing the patterns helps us understand contemporary phenomenon better.

Though there have been significant advances in understanding the cognitive biases that contribute to bubbles, none of the subsequent works on the subject is nearly as interesting or fun to read as Galbraith’s A Short History of Financial Euphoria.

No one should make a speculative investment before reading it– and perhaps not afterwards either!

Are you smart? That may be a bigger risk factor than you realize.

Once I was asked to speak to a group of union retirees about avoiding scams. As I was reading to prepare, I ran across a surprising finding, physicians are a common target of fraud. Why? Because they tend to be busy, smart, have wealth, not trained in finance, used to being in settings where they are knowledgeable, and embarrassed to appear foolish or unknowledgeable. 

Some doctors are savvy investors, of course, but many are also fleeced. If you are smart, you are probably used to getting better outcomes than people who aren’t as bright. This might make you think you can apply your better-than-average brain to a new challenge: investing. 

You might be right but you (like most people) are subject to overconfidence bias. I am not sure it has ever been studied methodically, but I suspect people who are used to succeeding are more prone to making poor investments on a large scale. Are you smarter than average? Then be extra wary!

Do you understand it?

This may seem obvious but if you don’t understand it, it’s probably a bad idea to invest in it. In 2006, I lived in a modest rented house in Mount Pleasant, a nice neighborhood in DC. Real estate hype was everywhere. On a lark, I looked up prices for similar houses to mine. We paid $2000 a month in rent for a 3BR row house. My share was $735. Similar houses were going for about $800k, sometimes more. I did the math. My monthly costs would more than double. I didn’t get it. 

Why would anyone want to pay twice as much in order to buy a house?

It didn’t make sense to me. I thought I must be missing something, but I didn’t understand it, so I didn’t move forward. I felt worried, and like I might be missing out. It turned out that my math was right! The market was overheated, and it doesn’t make sense to pay twice as much to own. The next year the real estate meltdown started, and since then rental prices and ownership prices have equalized to a much greater extent. 

Similarly, when I first heard about Bitcoin, I didn’t understand it and, frankly, like most people, I still don’t completely understand it. I knew that people who had invested early made a lot of money, but that didn’t mean it was a good investment now, just that it had worked out previously. As I learned more about Bitcoin (BTC) I became more and more skeptical. I am glad I worked to understand it *before* investing. The buyers of tulips during the 17th century Dutch golden age would have been wise to do the same. 

Remember: Hit Pause Before Diving In

Regardless of whether or not these “red flags” apply to the investment you’re exploring, it’s wise to hit the pause button before jumping in feet first. Take time to carefully evaluate the investment you’re considering, how volatile it is, whether you’re well-positioned to accept that volatility, and possibly running it by a fee-only financial planning team to get a non-biased, third-party opinion. When it comes to investing, moving slowly and thinking critically is an important way to insulate yourself against risk.

You should always consult a financial, tax, or legal professional familiar with your unique circumstances before making any financial decisions. This material is intended for educational purposes only. Nothing in this material constitutes a solicitation for the sale or purchase of any securities. Any mentioned rates of return are historical or hypothetical in nature and are not a guarantee of future returns. Past performance does not guarantee future performance. Future returns may be lower or higher. Investments involve risk. Investment values will fluctuate with market conditions, and security positions, when sold, may be worth less or more than their original cost.