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Don’t Get It?

Don’t Buy It!

Here is a hard lesson that seems to be consistently ignored and yet gets repeated over and over again: If you don’t understand an investment, don’t invest in it. The pitfalls of these glowingly pitched products may not be readily apparent, but they often rear their ugly heads at some unexpected point in the future with disastrous results for investors.

Remember collateralized debt obligations (CDOs)? They were the complex, confusing derivative of mortgages and other loans that blew up in the planet’s face and nearly took down the global economy. They were baffling bundles of bits of bonds sliced, diced and reconfigured in such a way that most of the people selling them couldn’t explain them. The movie “The Big Short” is based on the last derivative securities debacle.

In the more recent past, a host of less than honorable investment peddlers convinced uncounted investors to place billions of dollars in a host of purportedly safe, high-income generating, tax-advantaged investments based on segments of the oil and gas industry. 

These products took on various structures from master limited partnerships (MLPs) to exchange traded notes (ETNs). These securities were designed to be anything but transparent. Their internal structure is so complex as to require book-thick disclosure documents – that few ever read.

When everything goes as pitched, “oil prices will never decline,” these convoluted investment vehicles appear to do what was promised. Nice dividends continue to be paid, and the prices of the underlying securities remain stable.

Yet, surprises that were never mentioned in the sales pitch – like plummeting oil prices from a supply glut leading to full storage tanks causing backed up pipelines triggering oil well idling – throws all those glowing promises out the window. Bankrupt oil producers can’t pay their dividends and are forced to abrogate pipeline agreements. This chain of events leads to a trail of bankrupt pipeline partnerships and shaky storage companies. Eventually, the house of convoluted energy partnership and ETN cards start toppling.

Not only are many investors in these heavily sold and barely understood products facing huge potential losses, they are also facing surprise tax bills on their supposedly tax-advantaged investment - as loans are written off causing taxable realized gains. Few novice investors – and not many experts – could have recognized these particular risks.

The only clues to the high potential risks inherent in these products – and most other investments that turn bad – were the sensational promises and the apparent complexity of the offering.

If you want to avoid future financial catastrophes, this simple advice bears repeating: If you don’t understand it, don’t invest in it.

Investing for Retirement Income III

April (and May…) Fool’s