Are you an informed or a naive investor?

As they say in poker, "If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.” – Warren Buffett in his 1988 Letter to Berkshire Hathaway shareholders.

Have you ever seen a new investment opportunity or strategy for the first time and immediately thought, ‘This is amazing, I have to be involved’? Most of us would say yes (at least once) and if you relied on hype and hope over due diligence, then you were investing naively. Perhaps it worked out for you, perhaps not. There is heightened risk in these situations: we don’t know the odds and they might not be in our favour. We are all vulnerable to these risks yet there are simple steps we can take to be an informed investor.

Ask this question every time you invest

Are you an informed or a naive investor? This is not a one-off question but rather should be asked every time an investment decision is made. We are informed if we know the opportunity or strategy well. As soon as we step outside our sphere of expertise and knowledge we become vulnerable. While experience can expand our sphere of expertise, no one has infinite knowledge and there is a point at which we step into an area where we have little knowledge. At this point it is the process we apply which will determine whether we invest naively or not.

Each of us is potentially a naive investor. If we make this mistake, then we invest without a strong grasp of the return potential of the investment and the risks to the outcome. While obviously this can lead to poor specific investment outcomes, we also end up with poorly constructed portfolios because we aren’t aware of the risks we are trying to balance. It can even leave you open to fraud (covered in the article No easy way to make money).

Retail investors with no investment knowledge are vulnerable. For instance, consider the first time they see a fund manager presentation or the detail and modelling that may appear in a financial plan. They may be impressed yet the quality of the manager or the financial plan may be low.

Examples of naive investing

Seasoned industry professionals are also vulnerable and perhaps more nonchalant to the risk. Some examples of naive investing for direct investors are:

• A stock analyst who changes sectors of coverage and immediately starts making high conviction calls
• A qualitative stock analyst who is introduced to some technology for screening and ranking stocks
• A fixed income analyst who is introduced to a new area such as structured credit
• A core (high quality/low vacancy) property expert who is introduced to a development opportunity.

For portfolio managers who invest via managed funds:

• The first time you analyse a fund outside of your specialty, for instance, you cover equity funds but meet your first fixed income manager who impresses you with their process for constructing zero coupon yield curves to work out the fair value of bonds
• The first time you meet a hedge fund which transacts long and short, uses leverage and derivatives
• Any strategy that is based on technology, such as when you met your first quantitative equity fund, systematic CTA (a CTA is a strategy, commonly computer based, which trades futures contracts), or high frequency trader.

For me the best (or worst) example was Basis Capital, an Australian-based hedge fund which allocated heavily to structured credit. Unfortunately it lost all its money during the GFC (though there are reports which suggest there could be court action to retrieve some of the lost monies). This fund had high ratings from research houses, was supported by financial planners and invested in by retail investors (under guidance from their financial planners). I doubt any of these parties were informed investors when it came to structured credit.

For a retail investor with no industry experience, every investment decision is one to which they may be a naive party.

Caution against being the patsy

No matter how wide your sphere of expertise, it is the actions you take when faced with a situation outside of that sphere which will determine whether you invest on an informed basis. The most crucial aspects are:

• Acknowledging that this situation is outside of your sphere of expertise
• Defining a benchmark level of knowledge that will make you suitably informed
• Developing a programme to achieve that knowledge benchmark
• Having the strength, discipline and governance structure to refrain from investing until the decision is an informed one. This may mean never investing in a certain opportunity.

While the above points apply to both retail investors and industry professionals, these groups face different challenges. Retail investors can find it difficult to expand their sphere of expertise. They may have no background in investing and may find it confronting and costly. They may be time poor because investing is an after-hours chore. Market professionals are at risk of bravado, tempted to overstate their sphere of expertise to justify their position and salary. They also face pressures to work to a timeline and face other agency issues such as the desire to be seen as an innovator.

Expanding the sphere of expertise

Knowledge is obtained in many different ways, but consider these components:

• Research – not only the opportunity or strategy but also the peer group for the strategy. The high frequency trading example is most illustrative: you can’t help but be amazed when you visit your first high frequency trader. Perhaps you need to visit ten managers in this space to properly understand the risks
• Advice – seeking professional advice can be money well spent, using experts who can expand a sphere of expertise while providing assurance to decisions. At Mine Wealth + Wellbeing we are doing this at the moment in the area of agriculture
• Decision sharing – it may be beneficial to have multiple people involved in the research to ensure there is a team level of knowledge and no blind spots
• Reference checks – talk with industry colleagues about the people involved and the strategy. Industry participants do not always make the most of this opportunity.

There also needs to be a preparedness to not invest because the level of required knowledge and insight has not been achieved. This is a common rule for many people who invest into hedge funds where lines such as ‘we only invest into strategies we deeply understand’ are commonplace.

Experience isn’t just a measure of time or knowledge of different strategies or investment opportunities. There is the extra dimension of understanding yourself, your strengths and weaknesses, and how informed decisions are made. It’s never much fun being the patsy at the table.