Invest in what you know and understand

Are you confused by all the terminology that is being tossed around in the financial and investing community? If so, today’s column should assist with clarifying some of the baffling language.

When it comes to investing, you should stick to what you know and understand. This has been the mantra of billionaire investor Warren Buffet, who is the world’s third richest man in 2018, since he gained control of Berkshire Hathaway in the 1960’s. Warren Buffet’s advice to investors: “What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.”

Warren Buffet has followed his own advice to: “Never invest in a business you cannot understand.” I regularly speak with people who have financial products or investments, such as annuities or REIT’s, and were either never told or did not fully understand all the terms and conditions of the financial product or investment.

You can reduce your investment risk by knowing and understanding the financial products and investments that you own. As Warren Buffet has said: “Risk comes from not knowing what you’re doing.” So let’s get to some of those buzzwords.

Asset allocation

Asset allocation is an investment strategy that attempts to balance risk vs. reward by dividing your investments among different asset categories or classes, such as stocks, bonds, real estate and cash. Asset allocation is just a fancy way of saying: “What do I own?” The goal of asset allocation is to maximize return based upon your risk tolerance, goals and investment time frame.


Diversification is a kissing cousin to asset allocation. Diversification is essentially not putting all of your eggs in one basket. You can reduce your risk by spreading your investments among various asset classes through asset allocation. Warren Buffet has said that “Diversification is a protection against ignorance.” With diversification, if one of your investments goes bad, maybe because you did not know it well enough, you do not lose everything, just that one investment.

For example, you may own a deferred variable annuity with underlying “investments” in mutual funds, and like many other annuity owners with whom I have spoken, you were given the mistaken impression that you are well diversified. What you are not told is that you actually are not diversified at all because you have all of your eggs in one basket, the annuity company basket. If the annuity company fails, all you have is an unsecured claim against the assets of the failed annuity company. You have no claim to the mutual funds you “own.”

This is very different than a traditional brokerage account in which the broker-dealer is required to keep your funds and investments in your account separate from their own. Unless the company steals from you, à la Bernie Madoff, when a brokerage company fails, the regulators just transfer your diversified investment account to another broker-dealer.

Exchange Traded Funds (ETF’s)

Exchange traded funds are very similar to mutual funds, in that they are a bundle of marketable securities, such as stocks and bonds. Also like mutual funds, ETF’s can be focused on an industry, geographic region or investment strategy. One of the biggest differences between mutual funds and ETF’s is that mutual funds are more likely to be actively managed, resulting in higher fund management fees and expenses. Most ETF’s are index funds which track market indexes and which do not need to be actively managed, resulting in lower fund management fees and expenses.

Fiduciary Standard

Financial advisors who follow the fiduciary standard are required to hold your interest above their own. That means that they are looking out for your best interest, and not theirs. You would think that when you are given financial advice from a financial advisor, they are always looking out for your best interest, but that is not the case. In reality, only a small fraction of the advisors out there use the fiduciary standard.

An advisor who is a Registered Investment Advisor or RIA, is registered with the Securities and Exchange Commission (SEC) and bound to the fiduciary standard when dealing with you. Certified Financial Planners or CFP’s are bound to the fiduciary standard for all financial advice beginning October 1, 2019; until then, CFP’s are only bound to the fiduciary standard when providing financial planning. Unless they voluntarily agree to abide by the fiduciary standard, most all other financial advisors abide by the suitability standard, in which they can and do put their own interests above yours.

Suitability Standard

The vast majority of investment advisors do not follow the fiduciary standard, but the suitability standard. With the suitability standard, the advisor only has to reasonably believe that any recommendations made are suitable for you, in terms of your financial needs, objectives and unique circumstances. An investment that is suitable for you doesn’t necessarily have to be consistent with your investment objectives and profile.

The suitability standard does not require that the advice to be in your best interest. The suitability standard allows the advisor to put their interests in getting a commission, above your interests. It has been estimated that 80% of so-called “investment advisors” in the financial services industry are just salespersons peddling products. They are out there peddling annuities and other high commission financial products for their own interest, using the suitability standard. You have an 8 in 10 chance that your financial advisor is a product peddler. That probably does not give you much comfort.


A fund that is no load means that there is no upfront sales charge or commission that you pay to the advisor when purchasing the fund, typically up to about 5.75%. Do not be lured into purchasing a no load fund just because there is no upfront commission. Look at the fund’s internal management fees and expenses. It is not uncommon for no load funds to have higher annual fees and expenses than funds for which there is an upfront commission. If you plan on holding the fund for a long time, the no load fund could end up costing you more overall than the fund in which you paid an upfront sales charge.

By Matthew M. Wallace, CPA, JD

Published edited December 9, 2018 in The Times Herald newspaper Port Huron, Michigan as: Invest in what you know and understand

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