“There are known knowns. These are things we know that we know. We also know there are known unknowns. That is to say, there are things that we know we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.” – Donald Rumsfeld
This Learning from Legends quote when spoken by then-Secretary of Defense Donald Rumsfeld in 2002 had nothing to do with investing. He was answering a press conference question about the possibility of the government of Iraq supplying weapons of mass destruction to terrorists (SEE VIDEO BELOW). It could be applied to a lot of things, but because I live in the financial world, I think it can be best used to describe finance, specifically investing.
Unfortunately, there are many unknown unknowns when it comes to investing and these don’t become known knowns until it is too late — that means when there is a significant financial loss.
Recently, we saw this happen when people lost almost all of their money by investing in an unknown unknown. Called an Exchange Traded Note (ETN), this vehicle increased in value as long as volatility remained non-existent in the equity markets. In one day volatility doubled and this ETN was all but wiped out, losing 96% in market value.
There were two mistakes investors made: One was not understanding the vehicle they were investing in, and the other was investing in a strategy that they didn’t totally understand, causing them to underestimate the risk involved.
Let’s first tackle the investment vehicle, the ETN.
The Difference Between ETNs and ETFs
If you read UNBROKE you know I am a big proponent of Exchange Traded Funds (ETFs). I love their transparency, low fees, tax efficiency and the ability to move in and out of the market anytime you want during market hours.
With an ETF you buy shares that represent partial ownership of the underlying asset held in trust. The asset can be a stock, bond or commodity. However, these are completely different types of investments from the ETN, which in my opinion should be avoided by Main Street investors.
The ETN is actually just a debt instrument issued by a bank or brokerage firm so all you own is the ETN itself. This can hurt the individual investor in a couple of ways. The issuer could become insolvent or the company’s creditworthiness could become an issue.
If the company becomes insolvent you simply become a general creditor and get in line with the rest of the unsecured creditors. You won’t receive any of your money back until after all of the secured creditors are paid.
Even if the company isn’t insolvent, but there are questions that it might be, that in itself could cause the ETN to lose value. These two situations can have absolutely no relationship with the asset that the ETN is meant to track, but because of the structure of the investment, the individual investor can be hurt.
If ETNs are so dangerous, then why are they even offered? You guessed it… Because of the fees collected by the issuer!
Ignoring the ETN Warning Signs
When too many people pile into one side of a trade, it becomes dangerous. Also, when you have to suspend reality to argue that an investment is going to work, you are surely setting yourself up to lose money.
Both situations occurred with the short volatility strategy and subsequent ETN liquidation. For a year the stock market had no major moves up or down. Volatility was at historic lows, and many people bet it wouldn’t change.
This was a very profitable strategy for two years, until it wasn’t, and it lost almost everything in a day.
It was totally unrealistic to expect volatility to stay at the low levels where it was. Markets are supposed to be volatile; that is why as market investors we are compensated with higher returns than we can earn in other low volatility investments.
You can’t expect to earn 21.83%, the return on the S&P 500 in 2017, with the volatility of a certificate of deposit. Yet that is essentially what happened in all of 2017. Of course, this was going to change, and when it did, in just one day people who bet against it were all but wiped out.
Investors Must Account for Unknown Unknowns
Investing is hard; understanding how to control our behaviors so it doesn’t impact our returns in a chaotic and random market is even harder. These are the known knowns and the known unknowns.
If you ignore the fact that there are unknown unknowns, and don’t try to understand what they are, you are setting yourself up for some very painful life lessons and significant financial losses.
If you haven’t recently reviewed your financial plan you should contact your CERTIFIED FINANCIAL PLANNER™ Practitioner.
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