Asset Matters

Making an investment ­mistake based on sound judgment and wise counsel is one thing; ­making a mistake based on poor advice is another matter

FOR SEVERAL YEARS, I have been following a friend’s adventures in the stock market. He’s just an average guy who received a modest inheritance and decided to see if he could make it grow.

An investment advisor (or so he represented himself) steered him away from blue chips, saying they did not offer enough potential for substantial growth. Instead, he urged him to look to so-called “small cap” companies, where the risk is greater, but so (supposedly) are the rewards.

Maybe. His portfolio is now worth half of what he started with. Not only did he reap no profits, but his nest egg has lost half its value. No surprise there, you say. That’s what happens with small cap stocks.

But that’s not quite the whole story. My friend did not throw his money blindly into the first companies that came along. He looked at his (former) advisor’s suggestions and researched them to the best of his ability. In each case, the company had a product or service that seemed to stand out from the competition and hold genuine promise. The thing is, they all still do, even as their share prices slowly sink into the sunset. So what went wrong?

In most cases, he doesn’t know. What he has learned, and what he called me to share, is that the companies who provided his bath water had several things in common. They had an attractive sales pitch, management teams well-known in their industries and something tangible to offer.

What they also had were senior management drawing significant salaries, and numerous stock options and lifestyle perks. Even while their companies were floundering in the competition of an open market, they continued to bleed cash out of them by way of salaries and bonuses. If the companies went flat or under, they simply moved on to another one, often with their reputations seemingly intact.

There are a number of supposed regulatory safeguards to protect people from outright fraud, but he doesn’t think fraud is the right term for what happened to him. He’s not accusing anyone of deliberately misleading him, but he has no doubt the results wouldn’t have been much different if they had.

Each of the companies in which he invested continues to operate, and to spin plausible stories about their futures, albeit with the required warnings that all assumptions about their expected eventual share price increases are highly
speculative. And management continues to draw compensation that would make a pirate blush.

I assumed he was telling me the story as a preamble to suggesting such companies should be more strictly controlled by the government. But as he noted, start-up companies need to be able to go to the public for financing, and without that ability many useful and ultimately profitable products and services would never stand a chance.

What he really wanted to share was his belief that stocks such as those in his portfolio really should be avoided by all but the savviest investors, no matter how promising they may seem. Many brokers will do their best to steer their clients away from such risky ventures.

But others, like the one he used (who has since left the industry, no surprise), are only too happy to take investors’ money and put it into stocks with great promise on paper but a very tortuous path to success.

So, what did he actually take away from his experience, besides a shrunken wallet?

“You should tell your readers,” he suggested, “that investments that seem to be too good to be true almost always are.”

That may be a cliché, but he is correct that it bears repeating, as often and as loudly as possible.  Jim Chapman