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Willy Wonka Meets Wall Street

February 16, 2014

(Reprinted from the March 2014 edition of the Bath Country Journal)

In a popular children’s story, the young hero pins all his hopes on finding one of a handful of “golden tickets” hidden among millions of candy bars. It seems many people approach investing the same way. The notion that the path to long-term wealth lies in locating secret and previously undiscovered treasures in the global marketplace of securities is one regularly featured in media and market commentary.

One magazine, for instance, runs a feature called “Fund Managers’ Secret Stocks,” referring to supposedly “bargain” stocks the pros keep hidden. (How the stocks can be secret when splashed on magazine stands nationally is not explained.) Likewise, a popular business broadcaster regularly tells its viewers about the “under-the-radar” stocks that Wall Street analysts do not want them to know about.

This stuff sells because it plays to a misconception about how markets work: that they are like beaches after a hot day, full of buried treasures. All you need, in this view of investing, is a virtual metal detector to find the money that people left behind. You could get lucky this way, of course. However, basing a long-term investment strategy on stumbling across the equivalent of a mislaid trinket in the sand or a golden ticket in a chocolate wrapper is not likely to be sustainable.  It is a haphazard approach, reliant on chance and requiring a lot of work that is unlikely to be rewarded. Worse, it means taking unnecessary risks by tying one’s fortunes to a handful of securities or to one or two sectors.

Taking big bets on a single sector or commodity is a bit like buying a chocolate bar in the hope of finding a golden ticket. There is an element of potluck, and you are exposing yourself to idiosyncratic risk related to that sector or industry.

On the subject of hidden treasures, gold itself can have a special allure for investors, particularly in uncertain times. Indeed, the yellow metal has had a couple of spectacular runs, in the 1970s and in the 2000s. But there have been long lean times and significant volatility in between, which makes gold a highly speculative bet.

In early 2013, the Daily Mail in the UK carried the headline, “Gold Set to Shine Even More Brightly in 2013.” The rationale was that with investors scouring the world for “safe havens,” gold could reach as high as $2,500 an ounce by year-end. As it turned out, gold suffered its biggest annual loss in three decades last year, with its spot price falling 28% in US dollar terms. From an all-time high of $1,920 in September 2011, gold fell to just over $1,200 by the end of 2013.

Now, one can argue that adopting some exposure to gold may well suit some investors as part of a broadly diversified portfolio, but taking speculative bets on a single commodity, sector, or stock is more akin to blind hope or gambling than to anything else.

The popularity of media stories about hidden bargains and undiscovered stocks is understandable. Like townsfolk in a bar overhearing the boasting of gold diggers down from the hills, we desperately want to believe in El Dorado. However, this sort of speculation is no different from gambling.

In contrast, sound investment starts with identifying the risks worth taking and minimizing the risks that do not come with an expected reward, like taking a big bet on gold or betting on the Super Bowl coin flip. You can help reduce risk by diversifying into assets that behave differently but have positive expected returns.

It is true that you can get lucky the other way, like the boy in the chocolate factory story. Nevertheless, the chances are against you.

 

Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and businesses with their overall wealth management, including retirement planning, tax planning and investment management needs.

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