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A Big Lesson for Little Investors

30 July 2012 3 Comments

What an investment bank’s multi-billion dollar screw up means for you.

There you are, sitting in a small apartment packed with roommates, and the news flashes across the television screen: Investment Bank J.P. Morgan Discloses $2 Billion Trading Loss.

$2 Billion, you think. Must be nice to have that much money to lose.

But don’t spend too much time envying the likes of J.P. Morgan. When the financial world came crashing down, the investment bank was among the few firms left standing on steady ground. The chief executive, Jamie Dimon, was praised as the-guy-who-got-it-right when the rest of the world got it so very wrong.

J.P. Morgan’s recent loss, however, reminds us of something that bears frequent repeating–learn from your mistakes (or those of others) or you’re bound to repeat them. And it also includes lessons for those of us with only a few dollars in the bank, who are looking to build wealth to last a lifetime.

What’s so astonishing about J.P. Morgan’s blunder, aside from the size of the loss, is that they did it by trading the types of murky investments that took many other firms out just five years ago. Some trading in so-called credit derivatives, it appears, was meant to “hedge” against losses in other parts of the portfolio; other positions were meant to generate their own profits. In the end, they both created losses of their own.

The most important lessons you can learn from J.P. Morgan are to always know what you’re investing in and to be mindful of your potential for making mistakes.

The first lesson seems so obvious, but is so often disregarded in the world of investing. Just look at the initial public offering of Facebook, widely regarded as one of the most disastrous of the past decade. Public enthusiasm for the stock prompted a big open, but disclosures before and after the stock went public saw it quickly plummet well below its offering price.

It seems clear that many investors, big and small, failed to accurately value the company. Many of the smaller ones likely fell prey to the herd–if everyone else is buying it, then I should, too. It’s about the worst investing strategy ever invented, and is still practiced by millions.

The cause: we don’t have enough time, expertise or resources to evaluate investments for ourselves. There’s no shame in not being able to analyze a stock; there is shame in not acknowledging it.

To avoid that fate, leave the investing to the pros, either by investing in mutual funds or so-called exchange-traded funds. Many mutual funds combine analytical expertise with diversification–the type of broad-based portfolio that performs best over the long-term.

But be wary: very, very few managers consistently beat the returns of the broader securities markets like the Dow Jones Industrial Average and S&P 500. But index mutual funds and many exchange-traded funds track those indexes, at a relatively low cost. And they hardly need a human brain to do so. Think of it this way: By investing in a broad index, you’re tapping into the accumulated wisdom of every investor buying and selling the underlying stocks. That’s far safer, and more effective, than buying Facebook “because everybody’s doing it.”

If J.P. Morgan’s blunder, and much of the financial news of the last five years, is any indication, we’d also be wise to appreciate our capacity to make bad decisions–and guard against them. Once you begin thinking and investing like you’ve got it all covered, you’ll become more vulnerable to unforeseen events and hidden risks.

To protect yourself, invest with this in mind: studies show that the negative affect of a loss is typically felt twice as much as the positive affect of a gain. That means that you’ll react more emotionally to losing money than making it; that can spell disaster for a well-managed portfolio.

Once you start selling your good investments to make up for a few bad calls, you’re compounding your mistakes, not correcting them.

Matthew Malone writes for the leading Roth IRA and online retirement planning resource, RothIRA.com. He is a CBS SmartPlanet contributing writer whose work has appeared in The New York Times, Cosmopolitan, Smartmoney.com, Fortune.com, Forbes.com, and other publications.

3 Comments »

  • Daliena said:

    Your article is caught my eye,very attractive, I'm so encouraged. I'll see them again!
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  • Accountant Wages said:

    I think the lesson here is that if the big boys can make investment mistakes, so can the small investor. But because the little guys have more time to devote to research and are not affective by any professional mandates, we have time to smell bad investments if we're careful.

  • Fun LA Tours said:

    In business you should be vary not to lose a single penny, let alone $2 billion