I finished reading the Big Short by Michael Lewis this morning. It was a solid read and I recommend it to all my readers. Without getting into too much detail, the book was about the people who bet against the subprime mortgage market during the height of the housing peak. Specifically, Lewis profiles a half a dozen very unlikely investors who made all sorts of money when the market went south.
My reasons for reading business related books is twofold. First of all, I enjoy reading them. Some people read romance novels, I read about the financial markets. The second and much more important reason I read these types of books is to learn something. If I can pull some nugget of information from a financial book, even if that nugget only makes me a few dollars, then reading book was a valuable use of my time. It also increases my knowledge base just a little bit, which hopefully comes in handy at some point.
What did I learn from The Big Short?
The lesson is very simple. I refuse to invest in financial stocks that have large investment banking arms.
There’s two reasons for my newfound trepidation. First of all, rouge employees can take substantial risks with a company’s money, risks that often turn south very badly because of the leverage involved. There is no other industry where employee risk is so scary. Often, a CEO has little to no idea what the trading desk is really doing. Employees in the big investment banks are given an incredible amount of freedom, an amount that seems staggering considering the amount of money involved.
The second reason is I simply don’t understand the world of derivatives. While Lewis does a good job of explaining the use of derivatives in the mortgage backed security market, I still don’t really understand it. The derivative market is really only understood by the players. The amount of capital at stake is staggering as well, yet another reason to avoid these investments.
In the interest of full disclosure, I own a small position in Citi. The position was initiated as a speculative play on the recovery of the U.S. financial system. The investment is currently down around 50%. While I have little reason to lock in my losses, you won’t see me investing in a financial institution like Citi unless I find it incredibly compelling.
Often you hear the mantra that you should invest in what you know. While I think only investing in companies that you’re intimately familiar is limiting your investment choices, I think that you should limit your investments to products you understand. If you don’t get it, don’t invest in it.