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How To Become A Sophisticated Investor

Brian Bloch

No one doubts the value and importance of investor education and sophistication, but many investors are not really all that sophisticated. Goldman Sachs was scrutinized for marketing complex securities to its investors without telling them that a major hedge fund had taken a short position against these securities. The so-called sophisticated investors lost about $1 billion in this synthetic collateralized debt obligation (CDO).

The SEC investigation of Goldman Sachs has emphasized that even institutions rely on sellers and may be misled just like anyone else. This is particularly, but by no means only, the case for highly complex products, which “you need a PhD in finance to understand”. Indeed, critics at the time commented that the distinction between sophisticated and unsophisticated is artificial or doesn’t even exist, at least not where there is provable negligence and mismanagement.

Nonetheless, education and knowledge are probably the most effective tools for raising returns and lowering risk; and in particular, for avoiding truly disastrous losses. Sophistication, in the sense of learning how to get the best out of your money and from the investment industry, is fundamental. But it does not and should not in any way reduce the responsibility of sellers to make clear what they are promising and to do just that.

In this article, we consider how to ensure that you really and truly understand your investments and don’t overestimate your capabilities and knowledge. Furthermore, it is necessary to make sure that what you know and don’t know are not used against you at some point in the future.

What is a “Sophisticated Investor”?
In the sense used here, we mean someone who has sufficient investing experience and directly relevant knowledge to weigh up the potential risks and benefits of an investment opportunity. In other words, the person genuinely understands what he needs and wants, and what he is getting from the seller.

At a minimum, such investors will ensure that their portfolios are 1) sufficiently diversified, 2) monitored regularly (by themselves or someone else) and that 3) inertia is avoided, so that buying takes place when markets are relatively low and vice versa. Investors who fail to heed these three basic principles are most certainly not sophisticated. We are not referring specifically to a legal concept here, but rather how to be sophisticated in such a way as to do well with your money.

Good Ways to Raise Your Sophistication
Be aware that information provided by the industry is often difficult to understand, and sometimes deliberately so. The Goldman Sachs case reveals just how real this danger can be, through information asymmetry. A little financial knowledge can be a dangerous thing, so take the time to read all documents and contracts properly. If they are too long and complex, ask the seller for a clear summary, or even pay a lawyer to check it for you. It may be best to avoid some products simply due to their complexity and opacity.

Be disciplined and devote a certain amount of time not only to managing your money but also to keeping abreast of current developments. At least once a week, you should have a look at the financial pages of a newspaper or internet, and there are also various newsletters and magazines you can subscribe to. Prioritize carefully, deciding what to skim, what to read in detail and what to keep for the future.

Adopt an interdisciplinary and multifaceted approach to educating yourself. Draw on as many of the multitude of available resources as possible. Don’t rely just on the internet, but use books, magazines, newspapers, radio, TV and personal contacts. Also, bear in mind that the investment universe spills over into many fields including politics, psychology, sociology, the environment and law.

Be Aware of Your Own Limitations
This applies to your previous education and experience, time, interest and motivation. New things are always coming onto the market, so the time and commitment are ongoing. If you are not really interested in financial matters or even have a phobia about them, don’t push yourself too hard, and get someone else to do it. Be honest with yourself about all the above factors.

Accordingly, if you have other people managing your money, ensure that you meet with them regularly and have enough time to communicate meaningfully and bilaterally with them. Personal meetings are far better than phone calls, which in turn are better than emails. Even sophisticated investors need good and productive relationships at the human/money interface. Indeed, if done right, this is a good reason not to go overboard with internet investment.

Delegate all appropriate activities to the right people. Somewhat ironically, one of the most important elements of investment sophistication is to know what you don’t know, and to be able and willing to find out who does know and who is on your side. Even the most sophisticated people do not know about everything. Even within one area, such as bonds, there are experts who know far more about one type than another. Furthermore each company, each asset and each market has its own experts. Thus, part of being sophisticated is tracking down experts with the right skills and letting them guide you.

Avoid Misuse of the Term “Investor Sophistication”
Do not let your sophistication be used against you. The crux of Goldman Sachs' defense was based on the fact that the investors were sophisticated, and therefore could make a reasonable decision based on the information provided, which in effect means that the investors had limited or even no legal rights. To protect yourself down the line, when you buy products, ensure that the nature of the investment, how it works, and your objectives and risk profile are all clearly documented in writing.

It is also often worth pointing out to the seller, in writing, what you are relying on them to do such and ensure a balanced portfolio, monitor the markets and keep you fully informed of changes. You can also do this in greater detail, depending on the investment. Then, if things go wrong, they cannot claim that as a “sophisticated investor”, you knew everything and should have done part of their job yourself.

Investor sophistication is a rather vague and rubbery concept, but one thing is clear. Liability for mismanagement cannot be evaded legitimately by shifting the blame onto an investor simply on this basis. Make sure up front that you are well protected against this notorious seller defense.

There is a lot of misunderstanding about who really is a sophisticated investor, what this implies in terms of skills or active management and how to benefit from the associated skills. True sophistication entails a mixture of knowledge, understanding, experience and, equally important, delegation to specific experts.

Furthermore, the world of money is ever-evolving and revolving, so your knowledge needs to be updated constantly, and this also applies to the people you deal with. That is, they have to keep up with the trends too, and if not, you need to replace them. In summary, the trick of real sophistication is to manage your overall investment process optimally, rather than trying to know and do it all on your own.

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