I recently had a chance to ask Steven Sears who writes The Striking Price column at Barron’s and is also the author of new book The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails a handful of questions. He was kind enough to provide some really fleshed out answers to my questions, so I am going to run one each day this week. You can read the earlier posts in the series here: part one, part two and part three. Without any further ado here is part four:
AR: Wall Street is in the business of selling novel products and solutions. What approach should investors take to new financial products?
SS: Most, if not all, new products should be ignored, and probably shunned for six months to a year. That’s a good rule for individual investors. New products can be like roach motels that are easy to get into and hard to get out. You want to see new products establish a track record, and meaningful liquidity and trading volume. Institutional investors are always skeptical of new products. Before the products are launched, they ask for years of data and performance metrics to back-test the product to understand how it behaved in different market cycles.
Individual investors rarely do anything of the sort. Instead, many fixate on one key point to the exclusion of others. The leveraged ETFs and ETNs are a great example. Few people read the fine print and they buy and hold daily trading instruments. While writing Indomitable, the president of a brokerage division told me he lost $50,000 trading some double- or triple-inverse financial ETF because he didn’t realize it was a one-day trading product he had to sell by the close. If the experts have trouble, let it be a warning sign.
The lure of these new products is that they entice investors with things investors have a hard time doing for themselves. If you can’t trade futures don’t worry. There’s en ETF or ETN for that. Don’t understand volatility, no worries. Ditto for commodities and just about anything else you can imagine.
During the credit crisis, a big trading firm was stuck with a huge position in municipal bonds. The markets were frozen. No one would trade with them. The firm ultimately created ETFs because they knew retail investors would buy them, and that’s just what happened. I am increasingly of the opinion that new products are sometimes created to distribute troubled positions to unsuspecting investors. I cannot prove that point, but it’s worth contemplating, especially when you are offered a new product designed by financial engineers or very sophisticated investors. Remember the old saw about poker: if you’re sitting around the card table and you can’t figure out who the fool is, it’s you.
Tomorrow we wrap our series with Steven Sears on the topic of the financial illiteracy crisis in America.