A Simple Test For Any New Investment Idea

Posted on September 15, 2014 at 7:21 AM PDT by

Whenever you meet new people, instead of asking the typical “What do you do” question, turn it around. Ask instead, “What do you tell your parents that you do?”

This always gets a laugh. Most people in technical and professional jobs are doing things every day that their parents’ generation would have a hard time conceiving of as a real job.

Not that our parents are dumb, but the economy has become increasingly specialized. Jobs often are very narrow, the tools custom built and the language and concepts around everyday tasks are far from the stuff of cocktail chatter.

investment idea

You can do the same thing with investments. If a financial advisor comes to you with a new investment idea, don’t let him or her overload you with arcane, insider descriptions of why this new fund or this new asset class is the best investment idea ever.

Instead, say “Explain it to me like I’m your mother (or father).”

Guaranteed, your advisor will stop mid-sentence and stare a bit, like a deer trapped in headlights. See, selling an investment idea to a client is easy. Selling it to one’s mother, well, that’s hard.

“Hmm,” your advisor will say, “See, these bonds, uh, work like a stock in most markets, but when currencies start to move against, uh…” In short, it can’t be done.

Unless it can. One very good answer to this would be owning stocks. “Well, you see, you own a small piece of a very large and profitable company. Because you are an owner, you get a small bit of the company’s income. Also, we believe that over time more people will want to own this company, so the price is likely to rise from what we paid.”

Or, bonds. “A government, in this case the U.S. government, needs to borrow money to pay for its operation. It’s borrowing that money from a lot of people around the world, including us. It is very likely to pay back the money in full plus a small extra bit of money. We own this because it’s safe and, over time, can become more valuable to others.”

Plain language

Even small caps can be explained in an easy way.  “There are a lot of new companies trying to get a foothold in the market. Some will exist in 10 years and some will not. By owning a large collection of their shares in an index fund, we are more likely than not to own the winners after a few years has passed, and their winning ways are very likely to outweigh any losers in the bunch.”

See, that’s small cap investing and index funds explained in a way that anyone can understand. So that’s your simple “explain it to me test.” Any new investment idea that comes down the pike, just ask your advisor to break it down into plain, mom-friendly language.

If he or she can do it and you remain convinced, great. If not, it’s probably better to stand back and let someone else take on the risk.