Rules of the Road for Successful Investing in 2009

May 8, 2009

There are opportunities to be found, and good places and people to invest with even in this challenging period. Here are some "rules of the road" for successful investing, which do not include keeping all of it in cash under your mattress.

The last six months have not just seen a collapse of major investment institutions but fraud on a massive scale. Given the situation, you might be tempted to convert all of your investments to cash and sit on it. However, there are opportunities to be found, and good places and people to invest with even in this challenging period. I’d like to share some of my “rules of the road” for successful investing, which do not include keeping all of it in cash under your mattress.

Rule 1: DIVERSIFY

Do not place all or most of your eggs in ANY one (or related) baskets. Your investment mix absolutely needs to be spread among different asset classes, managers, industries, geography and over an extended period of time. You can effectively have one primary advisor who helps you to accomplish this.

Rule 2: Don’t rely on size, brand names or reputation

As this year has all too painfully demonstrated “large” and “well-known” does not necessarily mean smarter, safer, or more predictable. In fact, the size (especially the extreme size) of many multi-billion-dollar institutions may not be your ally. After all, in order to give returns to investors when you have billions in assets, you must earn millions if not billions of dollars in profits. These giant funds have to place big bets in order to make enough profit to move the needle, and there are only so many good deals that can deliver enough profits on this level. Often, a smaller operation can be much more nimble, given its ability to more selectively cherry-pick smaller opportunities that could potentially be very profitable but are too small for a big institution to care about.

I am not suggesting that big funds are necessarily riskier than small funds or vice versa. But you should be aware of the implications (both positive and negative) about the size of an offer and not fall into the “bigger is better” trap. A corollary to this is the notion that because it is popular and “everyone else” is doing it makes it better. Clearly, this thinking is potentially a fool’s errand.

Rule 3: Insist on transparency

When you invest your money you are absolutely within your rights to demand to see for yourself exactly how it will be deployed. If someone is not willing to openly share this vital data with you, definitely think twice about making the investment. What does transparency mean in practice? Well, I can’t speak for other companies but I can tell you what it means at Mickelson Capital. It means that you or your advisors can call or come to our offices on short notice and review all the documents and details surrounding any of our investment deals.

Rule 4: Due diligence is of paramount importance

The chances are that you are not personally in a position to do due diligence on a proposed investment. If you can’t do it yourself, have someone you trust review all aspects of the investment and determine if it makes sense. Ask, do I understand what is happening within the investment portfolio? Is it practical? Honest? Fair? Transparent? And is it likely to succeed? Investing is complicated and can be confusing. You may need coaching and help to find advisors and professionals to do this on your behalf. Our door is open and we are here to help.

Rule 5: Invest without leverage

While leverage is not intrinsically a bad technique (without it most of us could not afford a house), it should be used very cautiously. It is a particularly risky technique when applied to investments that, by nature, are volatile and have a meaningful risk of loss, such as stocks. Unchecked leverage was a principal cause of the 1929 crash and is a major factor in the current crisis. Leverage will magnify gains AND losses. To re-iterate an earlier point: one of the techniques larger funds employed to achieve their returns was to use significant leverage. Mickelson Capital Consulting does not ever use (or recommend) leverage to amplify invested capital.

Rule 6: Avoid third-party derivative investments

It is almost axiomatic that the more complicated an investment instrument, the greater the risk and uncertainty. The reason is that you are investing in something you don’t fully understand, and the developers often don’t either. That is risky. Do not take the word of a brilliant analyst (or worse, a salesman who works at a company with the brilliant analyst). The fact is that even in simple straightforward investments all of the possible outcomes are not known. Complex publicly traded third-party derivatives rely on a long, convoluted chain of events, with myriads of unknowable outcomes.

Rule 7: Take a simple, more fundamental approach

A fundamental approach is one that analyzes the underlying investment, fund, or company directly. What are the trends, metrics, and activities that may drive a proposed investment? It is important to understand the market and the company’s value proposition in that market. And, of course, one needs thorough financial due diligence. What is most important (and often left out by investors) is having a clear exit strategy from any investment.

Rule 8: Get personally involved

If I am going to trust someone with my money, I want to get to know that person. I prefer to be involved in smaller organizations where you can speak to, and get to know, the principals involved rather than rely on big organizations and big brand names. In benchmarking for investment decisions, I say: “You need to be able to get your arms around the people and your head around what they are doing with your money.”

David F. Mickelson, ChFC, AEP, is the President of Mickelson Capital Consulting.