Beginning Investment Strategies to Avoid

by Mr. Cheap

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On Tuesday I posted about Beginning Investment Strategies to Consider, and as promised, in this post I’ll detail investing strategies I think beginner investors should avoid.

There are countless people who want to get your money for a “can’t lose” investment.  I’ll try to talk about general “warning signs”, but inherently this is a topic that you can’t give a definitive list of what to avoid.

Zero Sum Investments

Gold, Forex, commodity, options and futures trading all have the characteristic they are zero-sum games (as wikipedia says, “a participant’s gain or loss is exactly balanced by the losses or gains of the other participant(s)”).  This means that to make money you have to be better than the average participant.  By definition, as a beginner investor you’ll very likely perform worse then average, so the people trying to involve you in these markets want to make money by either a) selling you a strategy, b) charging you for participating, or c) taking advantage of you and making money off of you.

Buying Trading Strategies

Some individuals will sell you a trading strategy for a zero sum investment, or even for other markets (particularly real estate or equities).  Usually there’s a good story behind what they’re selling, and they’ll talk about how they’ve made lots of money doing it.

There’s a saying at the horse racing track that “those who know, don’t talk and those who talk, don’t know”.  The idea behind this is if someone really had valuable information about an upcoming race, their best strategy would be to place a bet themselves and not tell anyone (since more people following the same betting approach will adjust the odds and make them less money).  The same is true for other investments.  If more money is chasing the same strategy, it becomes less lucrative for everyone participating.  This has happened with house flipping.  So many people are pursuing properties that are in need of cosmetic renovations that the price has been bid up to the point where it’s no longer a good way to make money.

If someone is selling their investment strategy instead of just following it themselves, that tells you something important:  they feel they can make more money selling it than following it.

Individual Bonds or Stocks

Evaluating the purchase of individual bonds or stocks requires a complex understanding of the market and the company’s place in it.  While knowledgeable investors can and do make money off of these, for the majority of investors (and especially beginning investors), ETFs or Index funds that track entire markets (or segments within them) are a far better choice.

Real Estate

We’ve posted on real estate investing extensively, and I certainly think it’s an interesting investment vehicle.  HOWEVER, I disagree with those who feel that it’s easy or simple.  Beginners can be eaten alive by “professional tenants” (deadbeats who work rental laws to avoid paying rent) or unintentionally running afoul of local rental laws.

Again, people do make money in real estate.  John T. Reed feels that to be competent in real estate requires mastering:

  • the real estate law of your state (or province in our case)
  • federal income tax law
  • property management
  • real estate finance
  • real estate leasing
  • real estate sales
  • real estate appraisal
  • construction (in some strategies)
  • securities law (in some strategies)

How many beginning investors are going to have ANY understanding of these areas?

Multi-Level Marketing (aka Pyramid schemes)

You’ll know you’re in MLM territory any time you hear a friend, family member or acquaintance start talking to you about a “business opportunity” or how to make money “selling to yourself”.  While some “investment gurus” will advocate these as a way to learn how to sell, as an investment they’re pretty miserable.  Any money you do make will probably be from friends who want to help you out (and view buying from you as a donation to the cause) rather than a true investment return.

Lazy Man and Money posted about Montavie (and was promptly sued), so that should tell you the kind of company behind these “investments”.

Innovative Investment Vehicles

It’s always tempting to get in on the ground floor of something new, and I put a little cash into peer-to-peer lending.  For the most part, I think the danger of something new far out-weighs any benefit from being one of the first people involved.  If it’s a worthwhile new market, very smart people will quickly move into it and being there ahead of them by a few months probably has limited value.  In the far more likely case that it isn’t worthwhile, it’ll be easy to lose any money you’ve put into it.

How to Gain the Experience to Invest in These?

While I feel that some of these investments areas are inherently flawed and should be avoided by everyone, some are worthwhile for knowledgable investors and a valid question might be how will I become an expert if I avoid them?

Some would advocate learning about them wthout any money on the line (e.g. trading stocks in “dummy” accounts without real cash in them).  Personally I don’t think you’d get much out of the experience if real cash wasn’t on the line.  One way to learn about these areas is to put a small amount of your investment dollars into them, keep the investment small, and learn as you try to grow it.  This could mean buying an older condo instead of a new 12 unit apartment building, buying $200 / month in stock usuing DRiPs instead of sinking a $100K inheritence into Nortel stock or putting 5% of your portfolio into futures trading (and refusing to add more money to it, you only reinvest your earnings).

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{ 10 comments… read them below or add one }

1 Ray @ Financial Highway

Great list I would also add to that:
Leveraged ETFs (Proshars, Horizon BetaPro etc..)
Inverse ETFs
Any exotic investment
Hedge Funds
Short Selling…

I dont think Network Marketing is necessarily a bad thing if you can find a good company and good product, it can be a great sales and marketing experience as well as generate a nice cashflow. But Agree that 90% of them don’t fall into that category.

2 Brian

Good advice Rob.

Once you understand that investing isn’t a “get rich quick” method, then good investing decisions will follow.

3 Henry

Beginner investors who are interested in index funds should look at A Quantitative Approach to Tactical Asset Allocation by Mebane Faber publish in The Journal of Wealth Management. It can be accessed here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=962461

I found SMA50 and SMA200 as the most reliable way of avoiding major crashes and by using SMA200, there were people who avoided the crash of 1987, 2001, and 2008.

Just my 2 cents.

4 Mr. Cheap

Ray: You list is definitely other investment areas that aren’t for newbies, good suggestions!

5 Lee

A very useful list of tips for newbie investors like myself! Thanks for taking the time to write (and thanks to the comment authors as well for their additions).

Lee

6 The Skilled Investor

Hi Four Pillars,

I looked at this article when I was editing the Carnival of Financial Planning. You make some very good points and I also agree with the comment by Ray @ Financial Highway.

Thanks for the quality article!

The Skilled Investor

7 Mark Wolfinger

Zero sum game is not a fair term to use when describing options because it is not always who wins and who loses that matters.

When options are used to hedge risk, both the buyer and seller of the option can win. When The option does it’s job, and risk is cut and profits are earned (on the whole, hedged position), it’s possible that the option buyer also profited. When that happens, nobody loses. That’s why options are a special investment tool, unlike other investments.

That doesn’t man they are for everyone, but not every option buy or sale is a direct attempt to earn a profit. Hedging is a far more important use for options.

Just a different perspective.

Mark

8 Mr. Cheap

Mark: Yes, this is true. It’s also true that a small allocation to gold can be worthwhile in an asset allocation, as it is a good inflation hedge and tends to have low correlation with other asset classes. And real estate, in the form of REITS or individual properties, can also have a place. And, and, and…

My point for this post wasn’t to say that all of these investment categories are “bad”, just that they’re inappropriate for beginners. If someone understands your point, clearly they aren’t a beginner, and power to them however they use options. If someone doesn’t understand what you’re talking about, then they should steer clear of options until they understand the issues enough to make up their own mind.

Just because they can be used to hedge risk DOESN’T mean that options aren’t a zero sum game. If you combine them into a more complex investment vehicle that makes money even when the option loses money doesn’t stop them from being zero sum game. If an options has utility for the investor beyond what is made or lost doesn’t mean they aren’t a zero-sum game. Options ARE a zero-sum game (that doesn’t mean they’re good or bad, it’s just what they are). “Zero-sum game” isn’t a pejorative, it’s just a description.

9 Mark Wolfinger

Mr C.
You make good points – especially about who should NOT use options.

The term ZSG is not that important.

10 Michael - The Fat Loss Authority

Completely agree with you regarding real-estate investing. Too many books and infomercials out there make it seem as easy as 1-2-3. Rich dad, poor dad series of books comes to mind.

Mike

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