Managing Risk With Franken-Products

Warren Buffett has long stated that successful investing is “simple, but not easy.” To which I like to add, “in the same way that dieting is simple but not easy.” Your mind knows you should avoid reaching for the next cookie, slice of pizza, or scoop of ice cream. But can your trembling hand resist it?

To help dieters resist temptation in an age of food abundance, an entire industry arose several decades ago offering all kinds of special pills and foil-wrapped “franken-food.” The pills and special foods were meant to help manage your appetite for the more straightforward fruits, vegetables, meats and grains that had a long, established track record of sustaining humankind. Unfortunately for many dieters, the special pills and franken-food lightened only their wallets, not their bathroom scales.

Many investors, I’m afraid, will likely experience a similar fate with some of the special products being offered by banks and brokerage firms these days as a way to participate in equity gains, but supposedly without all the risk of equities. As an example, structured notes — a hybrid debt and derivative product — come to mind.

These franken-products often come with a heavy price tag. Sometimes, it’s simply the out-of-pocket costs that make them an unattractive option compared to a more straightforward solution such as simply reducing your overall equity exposure.

But often there are also hidden risks in franken-products. Pricing even simple derivative products such as options and forwards requires a lot of assumptions to be made about future events; many more assumptions must be made with more complicated derivative products. If the assumptions don’t play out as expected, the franken-product can wind up being an expensive “sugar pill” or worse.

With food, a simple truth sits forever before us. We can have everything we want — every single olfactory and gustatory delight — as long we adhere to one simple rule: don’t take too much.

With investment risk and return, it’s pretty much the same, though admittedly figuring out what constitutes “too much” is a little more involved than counting calories. If you can’t be bothered to figure out your capacity for financial risk before shopping for a new portfolio, then at least keep in mind the most important rule for all investments products: there truly is no free lunch.