Before You Invest Your Money, Make Sure You Understand What You’re Investing In

I recently spoke with a prospective client who wants to make sure their advisor can advise on cryptocurrencies, because they own some.

Cryptocurrencies fall cleanly outside of my investment philosophy, which is, in a word, boring: low-cost, broadly diversified investments that try to match the market performance, not beat it.

I think it can be reasonable to put money (I am assiduously avoiding the word “invest”) in cryptocurrencies. Or ETFs based on the marijuana industry. Or the newest mutual fund promising to protect you from whatever the most recent market scare was. But only to the extent you’re willing to lose the money. Because, at the root of it, who the hell knows how those investments work?

This was a big problem in the 2008-2009 market crash. Collateralized debt obligations, credit default swaps…they were all the rage (until they most definitely were not). And, it turned out no one knew particularly well how they would work in the wide range of possible market conditions. Hell, after at least one very popular movie and countless interviews and articles and books, there’s still widespread confusion about these products.

And for the last year, of course, the “hot” investment is cryptocurrencies. I understand the fascination with it as a technology. But its role as a technology is almost entirely separate from its role as an investment. And Bitcoin’s volatile performance just this year (losing about half its value) should give every potential investor pause.

So, I suppose you could say that one reason I don’t invest my money or my clients’ money in things like cryptocurrencies, commodities, derivatives, and the like is that I don’t sufficiently understand how they work.  (Another strike against them? They’re generally expensive to own.)

What do I invest my own and my clients’ money in? Low cost, broad-market index funds and exchange-traded funds. Why do I feel comfortable investing in funds like these?

Because I understand how they work. And furthermore, I can help my clients understand how they work.

Answer These Questions Before You Invest in Something.

In a webinar about investing earlier this year for Tech Ladies® (and which is being held again this June 5…hint hint), I encouraged the attendees to understand an investment before they put their money in it. One of the women in the audience asked, and I paraphrase “How do I know when I understand ‘enough’? I have a PhD. I know the rathole always goes deeper.”

What an awesome question. And it left me blank in the moment. Always embarrassing.

I’ve been mulling on that notion of “enough” understanding ever since, because certainly even I don’t understand everything about the investments I use. And I’ve come up with a list of questions that I think will take you a long way towards understanding an investment. I can answer them for the investments I use for myself and my clients.

And I think you should be able to answer them about anything you want to invest in. If you can, then I think it’s fair to say you understand the investment “enough.” That’s no guarantee the investment will do well. But it makes getting taken by horrid surprise a lot less likely.

I’ve answered these questions for the Vanguard Total Stock Market Index Fund VTSMX, a well-known and very large index fund. I am not recommending this investment. I am simply trying to illustrate how you might answer these questions about any particular investment you’re interested in. [Yes yes, that’s some regulatory CYA right there.]

1. 1. What makes the investment gain and lose value?
      
      You’ve got to know this in order to know how your overall portfolio is going to behave.
      
      VTSMX will gain value when the companies in the overall US stock market do. Specifically, VTSMX tracks the performance of the CRSP US Total Market Index. “a This index contains “[n]early 4,000 constituents across mega, large, small and micro capitalizations, representing nearly 100% of the U.S. investable equity market”
      
      The overall US stock market should gain in value when there is optimism about the future of the economy, so should VTSMX. Conversely, when the overall stock market loses value, so should VTSMX.
      

 

1. 1. How does the investment behave in up markets? Down markets?
      
      This is a different way of asking #1. As noted above, because VTSMX simply tracks the US stock market (through a particular index with broad exposure to US companies), when the US stock market goes up, so does VTSMX. When it goes down, so does VTSMX.
      

 

1. 1. What is its underlying source of value?
      
      True investing relies on something having an intrinsic source of value. Cryptocurrency (as an investment), as far as I know, doesn’t have any intrinsic value. Its price is based on the “greater fool theory,” the idea that someone else will be willing to pay more than you are. A company, on the other hand, creates value by selling products or services and earning revenue that way. And rental real estate has value because people pay rent every month.
      
      VTSMX is a collection of, basically, all the publicly traded companies in the US. Therefore, its source of value is the value that all of its component companies create: the future revenues and profits from consumers.

 

1. 1. Who profits when I lose? Who profits when I profit? Who profits all the time?
      
      Knowing this helps you “align incentives.” Do you really want to own something where influential people/institutions will benefit when you lose? Because I don’t want to pit myself against influential people or institutions.
      
      If you’re invested in VTSMX, then when you lose, people who are betting against the US stock market profit. (Historically, not a good bet to make, as the stock market, again historically, has gained in value over time.) When you profit, fellow investors in the overall US stock market profit. Vanguard profits all the time, because you’re paying them an annual expense ratio regardless of how VTSMX performs (although the expense ratio is quite low).
      
      If your financial advisor manages your investments and charges you a flat fee, she profits regardless of how your investments perform. If your financial advisor charges a percentage of the assets she manages for you, then she always profits, but she profits more when your investments gain and less when your investments lose.

 

1. 1. How will this investment affect my taxes?
      
      Will it generate a lot of taxable income (via interest, dividends, or capital gains distributions) or is it “tax-efficient” (not a lot of such income)? If it’s tax efficient, then it’s reasonable to own it in a taxable investment account. If it’s not tax efficient, then you would probably lean towards owning it in a tax-protected account, like your IRA or 401(k), where nothing is taxed until you tax the money out.
      
      VTSMX is very tax-efficient. Most funds that track major stock indexes are. There’s just not a lot of buying and selling going on inside the fund, and that’s what generates a lot of the taxable income while you own it. If you look at Vanguard’s description of VTSMX, you can see that the “Return before taxes” and the “Return after taxes on distributions” are quite similar. Which means that you don’t lose much of your gains to taxes as long as you own the investment. And it means you can reasonably hold it in a taxable investment account.

 

1. 1. What are the alternatives to this investment?  Could I get a similar return or cash flow in a different, lower risk or lower cost way?
      
      This is a particularly important question for high-cost investments like annuities and cash-value life insurance, where you can often either find a less expensive version or create the same risk/return balance with a couple of more-basic investments. For example, annuities can sometimes be replaced with a CD (for guarantee) and a total stock market fund (for participating in market gains). And that’s a heck of a lot cheaper.
      
      Instead of owning VTSMX, you could get the same potential gains from different investments, certainly. Mostly other index funds that track the same or similar indexes. But that wouldn’t particularly help you lower risk or increase return or reduce costs.  
      
      You could own several funds which are more narrowly focused—you could own a large-cap index fund + a mid-cap index fund + a small-cap index fund, which altogether give you that total-market exposure—but that increases complexity. It also would introduce an element of market timing, because it would force you to guess, for example, if small-cap stocks are going to do better than large-cap stocks.
      
      I don’t know of any alternatives to VTSMX that give me the same return with less risk, or more return for the same risk, or the same cash-flow for a lower cost.

 

1. 1. How does the investment fit with the other investments I have? What role does it play in my investment portfolio?
      
      Do I expect it to behave the same as other investments I have? In which case, what good does it do to buy it? Do I expect it to behave differently (otherwise known as diversification)? How differently? The opposite?
      
      Am I buying this because I want to diversify (reduce risk in) my portfolio? Or am I buying this because I’m hoping to pick “winners”?
      
      VTSMX provides exposure to the US stock market, which complements exposure to the US bond market and the international stock market.

 

1. 1. How long has the investment been around? 
      
      If it hasn’t gone through at least one major market crash, you just don’t know how it’s going to perform. Remember the Flash Crash of 2010? Okay, maybe you don’t. My layman summation: crazy huge losses within one day of trading, caused by us not fully understanding how ETFs (exchange-traded funds) work. ETFs hadn’t been around long enough, and used widely enough, for us to adequately predict how they’d behave in certain market conditions.
      
      VTSMX has been around since 1992. It went through the Dot Com Bust (#1). It went through the Great Recession of 2007-2009. From October 2007 to March 2009, VTSMX lost about 53% of its value. And by January 2013, it had pretty much regained all that value (and of course continued to steadily gain after that until present day).

 

1. 1. How much does it cost to own?
      
      The more expensive an investment is, the less of the gain you’ll keep for yourself, and the more painful losses will be (because the cost will be added on top of the loss in value).
      
      VTSMX costs 0.14% annually to own. By comparison, mutual funds often cost around 1% to own. VTSMX is very inexpensive.

 

Understanding the Investment Isn’t Enough.

Understanding an investment is not the only factor in including it in your portfolio, of course.  There are the important matters of: What are you investing for? What is your risk tolerance?

Choosing your investments doesn’t require a PhD or a financial designation. But it does require serious thought. If you want to learn more about investing (which you should definitely do), I recommend you do some reading. A couple of my favorite books are:

1. 1. • How a Second Grader Beats Wall Street By one of my favorite curmudgeons of the financial world
      • The Little Book of Common Sense Investing By Jack Bogle, founder of Vanguard, creator of the first index fund, all around Dude To Be Reckoned With in the investment world.

[With thanks to friend and colleague David Meyers for his informative and entertaining suggestions. If you enjoy puns and you need a financial advisor, and especially if you live near Palo Alto, David’s your guy.]

Do you want help investing your money in a way you can understand? Reach out to me at  or schedule a free consultation.

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