This was first published by CFA Institute's Enterprising Investor.
I’m just going to come out and say it: Some of the stuff that Wall Street does is markedly less useful than a potato if you’d like to generate serious investment returns. I’ve done some work and found four investments that are commonly used despite being markedly less useful than the noble spud.
Before we get into my list, let’s consider the merits of the versatile potato, which actually is the least energy dense of the major staple foods, trailing corn/maize and brown rice by a factor greater than five. In fact, the only area where potatoes lead other staple foods is in water content, where they, of course, lose out in utility to a glass of water. That said, they never waste your time and are only mildly poisonous, and at wholesale prices that can be as low as $20 for a 50 pound sack, they are arguably reasonably priced. There are also many reasons to love them apart from how good they taste when fried.
Despite arguments in their favor, potatoes are illiquid, prone to going rotten, and infrequently used as investments by professionals. Though investment vehicles often come with well-designed tear sheets or prestigious packaging, one or more of these three characteristics apply to more of them than you might think.
The Questionable List
- Levered ETFs: Leverage is alluring. It amplifies gains and (as is often forgotten) losses, but critiquing levered ETFs is different from critiquing the use of leverage. If these securities only provided leverage, I would say that they’re probably not intended for amateurs but are not intrinsically bad for long-term investors. That is not the case. While they often succeed in matching the returns of the indices they are trying to track on a daily basis, the constant leverage they employ means that they cannot provide tidily leveraged returns. Research summarized in CFA Digestsuggests that the most likely long-term outcome for a levered ETF position is about 1.4 times the return with about twice the risk (as measured by standard deviation).
- High-Cost Variable Annuities: Nobody likes paying taxes, least of all me. Variable annuities offer investors the opportunity to put away money tax free and invest it in various securities, often deferring taxes until the money is withdrawn. I should love this, right? There’s only one problem: Most American investors could access that benefit essentially for free with an IRA or 401(k) account. So why would anyone ever buy a variable annuity? Well, they carry hefty commissions, which may lead salespeople looking out for their own interests to push them wherever they can. If you’ve truly maxed out all of your tax deferral options, it may be worth considering a variable annuity, but it’s doubtful the fancy one that the Brylcreemed salesperson is talking to you about is the right one for you. While we were doing the research for this primer on variable annuities, I found that there were almost always low-cost options available. I also found that a good way to see if something was expensive was to count the number of adjectives in its title. If it’s described as “premier,” “executive,” “accelerated,” or anything similar, there’s an excellent chance you can find a lower cost option.
- Stocks You Hear about in E-Mail Spam: It surprises me that anyone buys anything based on e-mail spam, but the economics of e-mail spam suggest that some people do. I and most professional investors would not buy a stock just because we got a research note from Goldman Sachs — even if it was hand delivered by Lloyd Blankfein — so why would you outsource your judgment to some random guy on the Internet? The tippers often suggest that they have knowledge a company is likely to introduce a new and revolutionary product, but in truth that’s most likely either insider trading or a lie. Often these spammers have large blocks of stock they are looking to unload onto unwitting suckers, and if you buy their story that sucker is you. You never want to buy anything you don’t understand, especially if the person telling you to buy it is a stranger on the Internet.
- Non-Traded REITs: In order to realize a return, you need to be able to perform a couple of important steps. The first is buying something at a price that it will likely go up from, but the second is perhaps more important: selling it for more than you paid. Investing in something where the latter portion of the process is imperiled is a bad idea unless the potential returns are so significant that they justify the risks . . . and you are truly qualified to evaluate those risks. Non-traded REITs, which are by definition illiquid and have charged commissions higher than 10% in some cases, have somehow managed to attract the love of their investor base. The arguments in favor of these vehicles often rest on the premise that because they don’t trade often, they are less risky. This is a facade. True risk is best thought of as the likelihood you will lose your money, not a statistical concept. Since commissions on these are so high, there is a certain loss embedded in the product, and it’s not like there are no alternatives. There are plenty of lists available online of publicly traded REITs, so I’m confident you can find a fund that suits your needs without paying a large upfront commission.
How’d I do? Do you think I’m being unfair to illiquid REITs? Too laudatory of potatoes? Leave a comment and I promise that in honor of a belated National Mail a Potato Day on 18 December, I will personally mail you a potato if you post in defense of any of these investments in the comments section. Make sure you also include your mailing address!If you liked this post, you should definitely sign up for my email newsletter.