The above quote is worth remembering whenever you’re told about a great new money-making idea or stock or whatever. What is the motivation behind what you’re being “sold?”
The financial services industry continuously introduces new “investment opportunities.” However, the actual opportunity to employ capital has not changed dramatically from the days preceding the founding of the major stock exchanges. Effectively, you have one entity in need of capital & you have another entity willing to lend the capital they hold (and forgo its current benefit) in return for repayment & more capital at a later date.
For a variety of reasons, we get disconnected from the fact that our investment choices arise from another entity’s need for capital. That disconnect is due mainly to the fact that we’re transacting in the secondary markets. We’re not buying stock or bond directly from a company. We’re buying it on a common exchange (secondary market).
On the other side of this transaction ultimately sits a CFO, Treasurer, bank officer, municipal board, business owner, etc attempting to raise capital at the lowest possible cost (rate of return to the lenders). It’s worth keeping this in mind when deciding how to employ capital. Especially when an “opportunity” comes along that is “exclusive” or “sophisticated” or requires a “timely response.”
The opportunity to employ capital does not change dramatically over time.
The packaging and marketing of “investment opportunities” is constantly evolving. Why? …well, it’s generally not the buyers coming up with the idea to say securitize multiple mortgage pools (based on default risk, repayment risk, geography, etc… it can get complicated if we’d like it to). It’s the sellers (those in need of capital today) and the financial institutions they work with that come up with these innovations. The purpose…increase demand by increasing the numbers of potential buyers (lenders). The increased demand effectively lowers the cost of borrowing (return required by the lenders).
This is not necessarily a bad thing by itself. The wider pool does indeed help to manage risk more effectively in many cases for the buyer & the seller. However, if the sellers are able to identify their buyers by individual or tranche, they can sometimes take advantage of certain buyers.*
Also, remember there can be too much of a “good thing.” While collateralized mortgage obligations were not completely new in the 2000s (in 1970 GNMA introduced the first mortgage pass-through securities), their proliferation certainly exaggerated some of the problems which surfaced in the late 2000s. Portfolio insurance by itself, not a bad idea. But it undoubtedly contributed to the severity of Black Monday in 1987. The list goes on.
The point is, sticking with some plain-vanilla investments (stocks, bonds, index funds) might not be all that “innovative,” but they are the proven ingredients for building wealth. From a return standpoint, you might not miss much by standing to the side when the latest financial innovation comes calling.
Keep in mind, whatever financial instrument you own, it should reflect the Net Present Value (NPV) of expected future cash flows. The more difficult it is for you to figure out those future cash flows, the more ambiguous your NPV might become. That ambiguity is not your friend.
* This is especially true when when the uninformed or unsophisticated buyer shows up (the term “unsophisticated” having nothing to do with intelligence, etc in the case, it’s simply a buyer who is not in this market on a regular basis). In that case, it’s a seller’s market. Buyer beware, the seller (initial offering) and/or the financial intermediary (secondary market) do quite a bit better when the unsophisticated buyer shows up.
Buying individual bonds can be very costly for the retail investor vs the institutional buyer. You have a fairly illiquid market and so price discovery is not continuous as it is in equity markets. Most individuals are more familiar with the liquidity & price discovery of stocks. They tend to assume the same for bonds. But the lack of liquidity means the financial intermediaries can clean up on the non-institutional participants in the bond markets. This is sometimes referred to as the “retail spread” in the bond market.