Why People Invest in Things They Don’t Understand

Have you heard this one?  “What do health insurance and hospital gowns have in common?”  You are a lot less covered than you think you are.  The underlying logic makes the case for working with an insurance professional.  But in the investing world, do people put their money into investments they don’t understand.  Yes.  This becomes another opportunity to show how financial advisors add value.

What’s the Problem?

It’s simple.  You’ve seen it in restaurants.  “I’ll have what he’s having.”  Many people hear about an investment a friend made and say:  “I’ll get some too.”  This can be particularly dangerous if they are buying online without an advisor as the intermediary.

What Could Possibly Go Wrong?

Let’s assume the investor has heard about something and made a purchase entirely on their own.

  1. When is it time to sell?  The barber who offers stock tips is a cliché.  Your barber might be a very good stock picker.  Making money in the market involves two points.  When to buy and when to sell.  Your barber might share an idea.  Do they know you actually bought?  Do they remember everyone who bought, so they can be told when their barber has decided it’s time to get out?  Does your barber want to be in the position of telling paying customers the idea didn’t work out, so it’s time to sell?  The investor is dependent for advice on person who isn’t an investment professional.
  2. Liquidity.  There are insurance products that might sound too good to be true.  Great features often come at a cost.  There might be hefty surrender charges because the buyer is supposed to be making a long term commitment.  Limited partnership investments can be similar.  Private equity and hedge funds assume you have other cash available for near term liquidity events.  The investor might find they can’t get at their money if they suddenly need it.
  3. They don’t know the whole story.  The investor heard about a product that has stock market participation while maintaining downside protection.  It sounded so good, they glazed over the details.  They stopped listening.  They later discover they get only a small portion of the stock market’s appreciation.  Even that move might be capped.  They thought they were getting one thing, but got another.
  4. Are their potential losses limited to the amount they invest?  Commodities futures contracts can sound incredible attractive.  You can leverage your money and make great profits!  You also have the potential of losing more than you invested if things go against you.  Commodities trades settle up at the end of the day.  If you are in the red, you need to make up the shortfall immediately.
  5. Trading on marginIt’s another leverage story.  The person investing on their own might understand losses come from their side of the equation and they might need to put up more money if things went against them.  They may not understand their brokerage firm has the right to sell stock in a client’s margin account, especially if the market moves sharply. They may not understand the finer points, like the concept of borrowed stock when shorting.  Ignorance is no excuse.  There’s probably some box they checked on the screen that said they read and understood the disclosures.
  6. Why this investment should work out (1).  It’s a complicated product.  They heard about it from a friend of a friend.  They called up or went online and bought some.  They don’t know what’s under the hood, only that it should work out.  It didn’t.  Their friend lost money too.  We don’t need to know how a Smartphone works.  We do need to know how investments work.
  7. Why this investment should work out (2).  They are very trusting.   They bought a stock because a friend bought it.  They don’t know what the company does or what needs to happen for the company to make money.  It might even be some off the wall idea where the technology hasn’t even been invented yet.  If they lose money, it’s embarrassing to say: “I had no idea what the company does.”
  8. Buying stocks to come back from the dead.  Braniff and Pan American are two historic bankruptcies that come to mind.  Some people feel they will somehow recover and buy the stock.  They don’t realize the companies are likely struggling under mountains of debt.  Common stock shareholders are last in line.  What has to happen for this investment to work out?
  9. The allure of penny stocks.  People fall in love with the idea you can own so many shares!  They think of the huge profits they can make.  If they own 10,000 shares, every time the stock goes up a dollar, they make $ 10,000.  It needs to get pretty far beyond a dollar before that happens.

Many people invest without having all the fact.  Adding perspective and highlighting risks are some of the ways financial advisors add value.