In this episode of Motley Fool Answers, Alison Southwick chats with Motley Fool personal finance expert Robert Brokamp and Amanda Kish, CFA, CFP, and Champion Funds advisor, about seven pitfalls to avoid while investing in stocks. Alison shares a story of a famously successful investor and his call to action to empower minority communities. Also, discover what’s in store for next week’s episode and much more.
To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
This video was recorded on August 11, 2020.
Alison Southwick: This is Motley Fool Answers. I’m Alison Southwick, and I’m joined, as always, by Roberto Brokampo, personal finance expert here at The Motley Fool. Hello, Bro.
Robert Brokamp: Hello, Alisono, or something like that.
Southwick: Ugh! That’s awful. Okay, look, maybe do better next time. So this week’s episode, we’re going to share with you The Motley Fool’s seven don’ts for successful investing over the long haul. All that and more on this week’s episode of Motley Fool Answers.
Brokamp: So, Alison, what’s up?
Southwick: Well, in the past, Bro, we’ve brought our dear listeners stories of the lives of famous investors, like Jack Bogle, John Templeton, and others. So today, I’m going to bring you the life, so far, of another famously successful investor.
So if I say the name Robert Smith, chances are that name doesn’t ring a bell, or if you’re a Gen Xer, like, Rick, then, yeah, the name does ring a bell. But, no, I’m not here to talk about the lead singer of The Cure. Otherwise, Robert Smith is a generic name that doesn’t likely make you think of someone famous, which is too bad, because Robert F. Smith is someone worth knowing. And today, I’m going to give you a book report [laughs] essentially on Robert Smith; the successful investor, philanthropist, and up until recently, quietly one of the richest men in the world and the richest African-American. Yes, richer than Oprah, someone I know you’ve heard of.
All right, here we go. I pulled most of my information from articles in The New York Times and [laughs] Washington Post. Funny enough, both of them were titled, both of the articles were titled: “Who Is Robert Smith?” And then also a bunch of articles from Forbes.com.
Robert Frederick Smith was born in December of 1962 and raised in Denver, Colorado. He was the son of two high school principals. And according to The Washington Post, his father instilled in him a love of music and his mother, a duty toward philanthropy and social justice. Everybody was hardworking. His mother would send a $25 check to the United Negro College Fund every month, and she had Smith on her hip during the famous March on Washington, where his little bitty baby ears heard Martin Luther King, Jr.’s “I Have a Dream” speech.
So Smith became interested in computers at a young age. As he put it, “I got hooked on technology,” Smith said. The excitement of figuring a complex problem out creates a eureka moment, it’s one of the best moments in life. So he applied for an internship at Bell Labs while in high school, but because the internship was for college students, he was told he was too young. So Smith called every Monday for five months and eventually got the position despite his age. He went to college at Cornell, studying chemical engineering, then took a job at Kraft Foods, where he was focused on — fun fact — coffee machine technology, and he actually won two patents for a stainless-steel filter and another for a brewing process that makes creme, the layer of foam on top of espresso. He also got an MBA from Columbia.
What did you guys do before [laughs] you were, like, 24 years old?
Brokamp: [laughs] I drank a lot of coffee; does that count?
Southwick: Yeah. In 1994, he joined Goldman Sachs in their mergers and acquisitions department, first in New York, and then he moved on to specialize in tech in Silicon Valley, advising companies such as Apple, Hewlett Packard, and Microsoft; not bad timing. After five years at Goldman Sachs, Robert founded Vista Equity Partners in 2000 along with co-founder Brian Sheth, and he’s been there ever since.
So what does Vista Equity Partners do? Well, I understand very little about what equity people do, venture capital, all of that, but I’ll just read to you from their site. According to their website, Vista invests in enterprise software data in technology companies through private equity, permanent capital, credit, and public equity investment strategy. So what does that mean? I don’t really know for sure, but let’s talk about it at least a little bit.
Early on, Smith saw the immense opportunity in software-as-a-service companies, which Wall Street wasn’t quite yet paying attention to. I mean, tech is cool, but SaaS, ugh! Yawn! Except that they make a ton of money and have fantastic margins. So Smith’s idea was that you don’t take a lousy company and slash and burn; you take a good company and make it better by offering guidance, advice, best practices, etc. So drawing on his background as an engineer and a Goldman vet, Smith wrote user manuals for running enterprise software companies. They cover efficiency but also incorporate cost-cutting measures, fee-generating ideas… They eventually named them Vista’s best practices. And this playbook is put to work in the companies they invest in and acquire.
As Forbes explains, “In isolation, many of the playbook’s best practices seem mundane, but software companies are often rife with eccentricities and legacy processes endemic to start-up culture.” We don’t know anything about that, do we, gentlemen? “Under Mr. Smith’s management, Vista established a remarkable track record by never losing money on a leveraged buyout and regularly returning investors 30% or more on an annualized basis.”
By the time he was 35, Smith had earned his first $1 million. And as he told The Washington Post, less than 20 years later, his first $1 billion. As of 2019, Vista has over $46 billion in cumulative capital commitments, owns over 50 software companies for a total of 60,000 employees worldwide. And it makes it the fourth-largest enterprise software company, after Microsoft, Oracle and SAP. I just cut and pasted that out of Wikipedia, so who knows how true it is, but it’s probably in the ballpark, right?
So much success — [laughs] no, no, Bro is just shaking his head, no. So much success, but Smith largely shunned the spotlight. He was so reclusive, in fact, that his company didn’t even have his photo on the website for fear that seeing a Black man at the helm might deter people. And as I mentioned earlier, if you google Robert Smith, anything written before 2016 is either about The Cure or is titled some variation of, “who is this guy?” But all that changed a few years ago.
As he said in an interview, “When I look at the folks that inspired me growing up, people like Frederick Douglass, they had to stand up and take positions in public in order to make a difference. Part of the responsibility I have, because of the opportunities I’ve been granted is to take leadership positions and help expand access for others.”
So I think only his accountant, and maybe his, like, personal assistant could give an exhaustive list of all of his philanthropic efforts, but knowing what I told you about his family, it probably won’t surprise you that his philanthropy is usually focused around education, social and economic equality, and music.
So famously in 2019, while giving a commencement speech at Morehouse College, Smith surprised that year’s graduates by announcing he would pay off all of their student loan debt. Do you remember this?
Brokamp: We mentioned it on the podcast; it was a […] from 2019.
Southwick: Yeah. So he has also served as chairman of Carnegie Hall and the Robert F. Kennedy Human Rights organization. He founded a summer camp in Colorado for 5,000 inner-city kids every year, and it’s focused on music. And he gave $50 million to Cornell to help improve the racial and gender diversity in their engineering department.
Smith wants computers and software to become for African Americans what the steel mills and auto plants were for a generation of Blacks in the early 20th century. Creating jobs in technology, Smith says, is the fastest way to create wealth today. Lately, Robert Smith has been busy circulating a call to action to the nation’s largest corporations and even individuals. And Forbes describes it as a private-sector solution to reparations.
Bro, have you seen this in The Washington Post or heard about this?
Brokamp: I don’t believe I have.
Southwick: Exactly, right? That’s what we’re doing, we’re going to talk about it here a little bit. So you can read his thoughts directly in a July Washington Post op-ed titled “How to Turn Our Collective Outrage Into Action.” But to summarize, I haven’t actually read this plan that he has written up, so I’m trying to cobble it together from a Forbes article and the op-ed and whatever, so if I get something wrong, I apologize.
In this op-ed, he writes that nowhere is structural racism more apparent than in corporate America. And he calls it the 2% solution, saying that large corporations should use 2% of their annual net income for the next decade to empower minority communities. He suggests they invest it directly into banking, telecom, technology, education, and healthcare infrastructure to benefit Black communities. By doing so, he says, it could begin to reverse corporate America’s history of structural racism.
So here’s one problem to solve. We’ve all heard about food deserts: communities where there are no grocery stores or healthy food to be found, you’re basically stuck eating from fast food restaurants and convenience stores. And Smith points out that these food deserts are also banking deserts and that 70% of African American communities don’t have a single bank branch, and only 21 banks in the U.S. are run by African Americans.
So here’s a quote I pulled.
Through his plan, Smith envisions the nation’s banking sector could, over the next 10 years, provide billions of dollars of capital to Black-owned banks and community development banks with some of the funds used to digitize these lenders. His plan calls for the telecom and tech sectors to provide money to help prepare 180,000 students in America’s historically Black colleges for the jobs of the future and to digitize 1 million minority small businesses.
So many companies, including The Motley Fool, are saying Black Lives Matter and that they support economic equality, diversity and inclusion, and he’s essentially saying, nice Instagram post, now put your money where your mouth is.
And so, as he writes in his op-ed, for The Post, “In finance we speak of ‘permanent capital,’ referring to investments that create long-term compounding returns. This is the approach that should guide companies in making practical, tangible, and scalable commitments.”
In closing, even the first self-made Wall Street billionaire experiences racism on a personal level far too often in his life. He told Forbes about a time he was out for a professional dinner with a bunch of Wall Street types. You can immediately picture it [laughs] as soon as I said that. Smith offered to pay, but a senior banker at the table refused to let him, and chortled — their word, not mine — “I can’t have a Black man buy me dinner.”
Brokamp: Holy cow! You’re kidding me.
Southwick: [laughs] No, and I’ll quote another story. As he told The Washington Post, at least three to seven times a year, he says, he is stopped by police as he drives himself to the airport in Texas. He lives in Houston, I believe, or no, Austin maybe. The officers run his tags and check his license, and he’s told he was speeding or changing lanes without signaling. This is three to seven times a year. And the officers send him off, often without a ticket.
As he says, you shouldn’t have to be fearful for your life, you should be able to drive to the airport and not be stopped three to seven times a year. But, as The Washington Post writes, Smith never worries about missing his flight; his private plane won’t leave without him.
And that, Bro, is what’s up.
Brokamp: We, at The Motley Fool, recently designated the seven don’ts about investing that we think everyone should heed. And here to help us explain them is Amanda Kish, who is, both a CFP and a CFA, the former advisor for The Fool’s Champion Funds service, a former financial planner with Motley Fool Wealth Management (a sister company of The Motley Fool). And now she’s embarked on a new role. Welcome, Amanda, and tell us a little bit about what you’re working on now.
Amanda Kish: Sure. Thank you so very much; I’m glad to be here today. So I am the financial planning team lead on the Member Services team. So a lot of my efforts are directed toward really bringing that financial planning perspective to everything that we do and the services that we offer here at The Fool. So in the coming months and quarters, members will begin to see a little bit more of that top-down portfolio guidance coming their way. We know you’re Fools, and Fools love stocks, but what we want to do is help members get a better understanding of how all of those stocks and our services work together with each other and what effect that has on an aggregate level. So incorporating that more holistic, total-portfolio view of investing.
Brokamp: And one of the things you’ve started contributing to is these seven don’ts, but also five dos. We’re getting to the five dos later on, but we have these seven don’ts. Tell us a little bit about the origin story of these and why we’re looking at these now.
Kish: Sure. So this effort with the dos and don’ts of investing really came about because of some of the things that we were hearing from members and how they were investing in this very challenging environment.
So 2020 has been interesting from many different perspectives, but it has provided really a very unique backdrop from an investment standpoint because the market fell so far so fast in the spring and then bounced back just as quickly, it really provided the opportunity for, kind of, a case study of investor behavior and how people respond to these elevated levels of volatility. So you really got to see a swing between these extremes of despair and elation in a short period of time. So based on what some members were telling us about how they were responding to this year’s market and how they were investing as a result, we started to see some common themes emerge. And we really wanted to get out there with, kind of, a primer or a refresher on how we think Fools should do stock investing and some of the basic Foolish principles we think they should adhere to.
And because we, obviously, don’t know exactly what the market is going to do next. So right now we’re kind of in that wait-and-see anticipation mode, we wanted to take this opportunity to remind folks of what we think they should be focusing on right now.
Brokamp: Great. All right, so let’s get into it. I’m going to read each one. Amanda is going to give her thoughts; I’ll add a few thoughts as well. So No. 1, don’t buy fewer than 10 stocks.
Kish: Yes, so this is really a question about diversification. Obviously, we’re Fools, so we believe in picking individual stocks, but when you only own a small handful of names, your portfolio is still pretty reliant on the fortunes of just a few companies, especially if they happen to be in the same industry, which a lot of the Foolish stock picks are. So owning at least 10 — and personally, I would advocate for 15, 20 more stocks — really reduces that level of company-specific risk in a portfolio while still allowing you the chance to benefit from owning those stocks in the first place. And it’s not a bad idea to supplement that with some low-cost broad market exchange-traded funds as well.
Brokamp: Yeah. And I wrote an article for Stock Advisor earlier this year, basically answering the question of how many stocks you should own. And I did a very informal survey of other advisors at The Fool, and most people said they’re aiming for 20, and maybe at least 30. And the other way to think of it, too, is how much should you have in an individual company? If you only own 10 stocks, that’s 10% of your portfolio riding on each company. Of course, they’re going to move up and down; you could easily get to a point where one of those stocks becomes 20%, 30%, 40% of your portfolio. And for most people, that’s more risk than they really should be taking.
Brokamp: Let’s go to No. 2: Don’t aim for short-term gains.
Kish: Sure. So I think this is probably one of the most difficult investing rules to stick to. It’s very much human nature to be tuned into what the stock market is doing from day-to-day, and it’s normal to feel a bit emotional when it comes to your money. And, you know, stocks fall, and we have a really volatile scary time, like we did earlier this spring; it’s very understandable that investors are going to be focused on what’s going on in the short run. But you’ll frankly drive yourself crazy doing that, and focusing on the short run also leads investors to make some very ill-timed, I guess, choices by selling or buying at the exact wrong time.
So if you’re too focused on what’s happened in the past month or six months or even a year, that can lead to trying to chase performance, where you’re perpetually shifting money to whatever stocks or asset classes have done the best in recent history, and that’s pretty reactive. So as hard as it is not to be swayed by short-term market movements, that’s really what you need to do to be successful and to avoid making decisions at exactly the wrong time.
Brokamp: It can be very tempting, and a lot of times, we talk about this in terms of the market going down, right? Like, in the March, the market went down 34%, we’re telling people don’t focus on the short term, but there’s the short-term gains part too, right? A company that The Motley Fool has recommended in the recent past is Zoom. Zoom is up 280% this year. And I’m sure there are many people out there saying like, “I should lock in these gains right now.” Now, I’m not saying Zoom is going to go up or down from here, but generally, the most successful investments in Motley Fool history have been ones that we have held onto for 5, 10, 15, 20 years, regardless of how well or how poorly they did in any given year.
Southwick: We talked about it earlier this year on the show about how, because casinos were shut down people were getting bored and they decided to start picking up investing as if it was like gambling. And it is when you’re doing short-term trading, it is very much like gambling and you get that excitement and you get that thrill when a stock shoots up, and you’re like, yes, awesome, and it’s such an adrenaline rush and so exciting. Whereas long-term investing, as we know at The Fool, is slow and steady, it’s not sexy or exciting but it will pay off [laughs] in the end if you have the patience to see it through. So I think it is fascinating to people who have picked up investing during this past year, are doing it out of boredom, are doing it because they’re a thrill seeker, they’re looking to replace some sort of excitement in their life.
And investing, that we found at The Fool, when done well, when done successfully is not super sexy and exciting; it’s exciting for us, but it’s more long term; it’s exciting over 10-year periods [laughs] over decades. Although, every now and then, you get a good winner that you’re excited about.
Brokamp: I also think of it as raising kids, right? Like, raising your kids is a long-term prospect, and you’re going to have days where it was just awesome, you did a great thing with your kids, other times may not so much, some more work. But you got this long-term goal of eventually kicking them out of the house. I mean, setting them off on … [laughs] and then they’re going to be successful or something like that. But anyways, so with [laughs] that said. So that’s all about stocks, and everyone knows we love stocks.
But let’s move on to No. 3: Don’t invest all your savings in stocks.
Kish: Yeah. And this point really has to do with risk tolerance or how much volatility can an investor handle and how they respond to short-term declines in the market. So as a general rule, any money that investors need over the next few years should be in cash, so that means everyone should have or at least work toward having an emergency fund to cover unexpected expenses. And then retirees should have enough in cash to cover the next two to four years of living expenses. And then beyond that, as a general rule, obviously investors who are younger, have longer time horizons, greater risk tolerance, can be primarily in stocks. So for them, something like 90%, 95% in stocks may make sense.
Then on the other end of the spectrum, someone who’s retired, drawing down on their portfolio for living expenses, can’t sleep at night when they lose money, they should be much less exposed to stocks. For that person, maybe something like even 50% to 60% stocks might be appropriate. It really depends on your time horizon, how much risk you can handle. And I know the rule you’re talking about, model portfolios, have allocations along that risk spectrum as well.
Brokamp: Yeah. And it’s been a tough one determining what’s the best allocation nowadays. So for the vast majority of the last several years — and Amanda, you helped develop these — it was: If you’re retired, 60% stocks; within a decade of retirement, 75% stocks; and then more than a decade from retirement, 90% stocks, 10% out. But given the fact that when you have money out of the stock market, you usually have it in bonds…bonds historically returned 5%, 6%, 7%, that’s an attractive return, you’re not going to get that from bonds now, you’re going to get, like, 0.5% to maybe 1%, 1.5%.
So just recently, in the Rule Your Retirement, I’ve moved the allocation for people who retired to 75% stocks. But for many people, that’s going to be too risky, way too risky. So sticking with 60% or even 50% is better. I’m doing this change with lots of trepidation and emphasizing that people need that — I call it an income cushion of five years, if you’re retired, out of the stock market. Historically, most bear markets have gone down and come back up, recovered within five years, so you should be OK. But we’ll see. I hope that continues.
I should also say that it’s sort of a default with most of the other Motley Fool services, which is to have about 10% out of the stock market. And I think that’s something that Tom Gardner has said many times over in the past.
All right. Let’s move on to No. 4. Don’t borrow money to buy stocks.
Kish: Yes. So this is buying on margin, basically this is a technique where your broker lends you money charging you a certain rate of interest for that privilege, obviously, which allows you to purchase more stocks with the proceeds from that loan. So basically, let’s say you have $10,000 and you borrow another $10,000 at 5%, you now own $20,000 worth of securities. Which is great if the stocks that you own go up in value and you make larger profit.
But the reason margin is so dangerous and why we have this in here as a don’t, is because stocks, obviously, don’t always go up, especially over the short run. And when that happens and you’re on margin, your losses are then magnified.
So just as a quick math example here, let’s assume that instead of going up, a stock that you’ve purchased on margin falls by 10%. So your loss is not 10% but then 25%, because you’ve lost $2,000, you eventually need to pay back that $10,000 loan and $500 in interest as well. So you’re left with that $7,500 on your original $10,000 investment, which is a 25% loss when the stock only fell by 10%. So it’s really easy to see how investors can get into trouble very quickly using margin.
Brokamp: The problem there is if your stocks go down so much, your broker is basically going to say, either you have to put up more collateral or we are going to sell these stocks for you, which basically locks in that loss, you’re selling at the worst possible time.
All right. Let’s move on to the next one. No. 5: Don’t buy stocks because they’re under $5.
Kish: Yes. These are what are called penny stocks, and they come with their own, I guess, unique set of risks. So one issue with these types of investments is that they tend to trade on over-the-counter markets not on an exchange, like, the New York Stock Exchange. So the requirements for financial transparency, corporate governance, that kind of thing, they aren’t quite as stringent. So investors may have less true insight into the actual value of the company.
And you can also have some issues with liquidity as well with penny stocks, which means it may be more difficult to buy or sell shares at the market price. So what all that translates to is basically these types of stocks tend to be a little bit higher risk, and a lot of that risk can be, kind of, hard to quantify. So investors may not really know what they’re buying. So that’s why we recommend just avoiding that corner of the market, especially since there are so many other great companies that we do have better insight into.
Brokamp: Yeah. And by the way, that definition of $5 per share or lower is a penny stock comes from the SEC. I know it sounds confusing to call a penny stock anything that’s $5 or less, but that is from the SEC. And one of the big issues really is it’s not the share price as much as the size of the company. These are often very small companies. As Amanda said, they’re illiquid. They can be easily manipulated. When you read about some story about how a stock price was — the old, pump-and-dump scheme, where a bunch of people on a message board said, oh, this company is going to come out with this new cure for cancer or something, the stock goes up and then it comes crashing down. Most of those happen with these small, illiquid stocks, because it’s so easy for a group of people to get together, pump up the price, and then sell at the top and leave the other folks holding the bag.
Southwick: Does that really still happen as much as it used to?
Brokamp: I think so. I think so. Yeah. And really, there’s no way to prevent it, really.
Southwick: Yeah, I guess so. It’s not something that, like, I know that was a big thing in the early days of The Motley Fool, I hear about that so often, it’s like a huge risk right now. And I think, understanding the difference between valuation and an actual share price, I think, is important for people, for maybe some of our newer investors to understand. So would you guys, like, maybe one of you could explain that a little bit about how — as a newer investor, I could see someone being like, but look, I can buy 5,000 of this $1-priced stock versus I can’t even get a couple of shares of Amazon for that. So can you maybe talk a little bit just to get a base level of understanding for maybe some of our newer investors about price versus valuation?
Kish: Sure. So the price is obviously what the company sells for in the market, whether that’s on the exchange or in the over-the-counter market. And ideally, that would be similar to what the valuation is, but in cases like these, you know, there’s not necessarily that correlation. If you don’t have that insight, it’s harder for investors to make that call on valuation. So the valuation is what a company’s cash flows are worth in the future, which should have an effect on the stock price.
But with those lack of regulations, there’s going to be a bigger disconnect there. So you really can’t make a call on a penny stock as you can for Amazon, who has much more widely available financials, they’re much more transparent, things like that.
Brokamp: Yeah. And I can see what you’re saying, Alison, where you look at one company and it’s selling for $500/share and another one is selling for $5/share. And you may think, well, the $5/share one must be a better value —
Southwick: I get to buy more of them.
Brokamp: I can buy more of them.
Southwick: More shares.
Brokamp: Right. But what it comes down to is it’s not the number of shares that you own, it’s the amount of money that you put into a company, because every time you buy stock, you are buying a proportionate amount of that company. You are a legitimate part owner of that company. And the number of shares doesn’t matter. It matters if you put in $10,000 in that company what percentage of that company do you then own. So that when it goes up, your investment goes up proportionately.
Southwick: And, of course, now we can buy fractional shares. You used to, as a new investor, you’d be totally priced out of some higher-share-price stock, but now you can do fractional shares, you don’t have that same problem.
Brokamp: Yeah, but companies do understand it, right? Apple just announced a 4-for-1 stock split. So there’s no question that people still look at these companies and think, “Oh, this share price is too high, I’m not going to buy into it.” You know, when you look at a share of Berkshire Hathaway A, they had to do something different, because before there were stock slices and fractional shares, no one could afford to buy a single share Berkshire Hathaway. So at some point companies do have to do it…
Southwick: Right, because it’s, like, six figures, right?
Brokamp: Oh, yeah, it’s well over $100,000, I haven’t checked lately.
Southwick: Yeah. Per share. Bananas. Yeah.
Brokamp: All right. Let’s move on to No. 6: Don’t expect all your stocks to go up.
Kish: Yeah. So it’s important to note that even really good stock pickers, great stock pickers will make some bad calls now and then. Not every stock that you own will make money, and not all of the stocks that you own will make as much money as you think that they should. But it’s important to focus on what you got right rather than on what you got wrong and not beat yourself up for owning the occasional dud.
David Gardner said before to aim for about 60% accuracy, where 6 out of the 10 stocks you own are beating the market. So that just means you have to be comfortable losing sometimes, because when you do win, those ones will more than make up for the losses.
Brokamp: For another article I wrote for Stock Advisor earlier this year, I did an analysis of the success rate of those stocks. And again, this is earlier in the year, so it’s changed since then. But of all the stocks that Stock Advisor has picked since — I think it came out in 2001, so it’s been around for a while — 30% of the picks had lost money, and 12% had lost 50% or more, so. And when you look at the whole record, Stock Advisor has crushed the market. So to get those market-crushing returns, you’re just going to have to put up with some real duds.
All right. Let’s move on to the final item here: Don’t use options in your first year of investing.
Kish: So options are basically an investment tool or vehicle that gives the buyer the right to buy or sell a certain stock at a certain price at a certain date in the future. So for example, you could buy a call option, which would give you the right to buy 100 shares of stock X at $50/share in six months. The idea here is that if you’re bullish on stock X and think it will be trading at $60 in six months, you could make a profit. And then if at the end of that six-month period, if stock X is trading above that, you would exercise that option; if it were trading below that, say at $45, you wouldn’t exercise the option, and it would expire.
Conversely, you can buy a put option that gives you the right to sell stock X at a certain date for a certain price, which you would want to do if you’re a little bit more bearish on that stock.
So options can be useful for a couple different purposes. They can hedge against risk. So if you own a lot of a certain stock and want to protect against market declines, you can do that with options. If you want to generate income, you can write or sell options yourself. And of course, the place where we really get into trouble is when options are used purely as speculative investments, which is why we recommend avoiding options as a beginning investor.
Brokamp: Yeah, when I first came to The Fool in 1999, we were all against options. We said that no one should ever have options, partially because most options are very short-term instruments, and we don’t believe in trying to make short-term bets on anything. But also, depending on what you do, it can be extreme leverage in the sense that if your bet is right, you make a lot of money, but if it goes the other way, you can lose a lot of money. And depending on the strategy, you could lose almost an unlimited amount of money.
That said, that changed a few years later, and I think that mostly came to Jeff Fischer, who ran our Options service and now works on the regulated side, managing money for The Motley Fool. So we do believe, as Amanda said, hedging is one thing. Covered calls is something else that we write about every once in a while as a very conservative strategy, conservative way to produce income. So in the right situation, I think that’s fine.
But I think it fundamentally comes down to, it’s generally a short-term bet, and it’s not a “set it and forget it” type of thing. I mean, I have come across people who start an options strategy and then just, sort of, forget about it, and then it kind of went against them and they’re like, oh, my goodness, [laughs] I totally forgot. It’s not the type of thing where you can buy a good company and then not look at it; you can look at it once a year and you’re fine. Options aren’t like that; it takes a lot more time and effort.
Southwick: Yeah, like, my husband loves options, he loves them. But he does them in a very Jeff Fischer kind of safe way, using them. And he absolutely loves them, and I would call it more, almost like a hobby, like something you do because you actually enjoy doing it, because if you don’t enjoy doing it, to your point, Bro, it’s a job, and it could go sideways pretty easily if you don’t understand what you’re getting into.
So I appreciate the idea that we want people to really know what they’re getting into before they get into options, but they are a really great tool if it’s something that you enjoy doing and love squeezing, squeezing that, like, my husband just loves squeezing a little bit extra more money out of these little corners with options and stuff, and he enjoys it, which is great, but I wouldn’t want to do it. Just give me some shares or something and I’ll sit on them for a decade.
Brokamp: Yeah, I have a cousin who does the same thing. He works from home; of course, we’re all working from home, but he’s always been working from home. And when he’s not working, he’s looking at the options market. He says he does very well. I have every reason to believe him. but it definitely takes some time.
Rick Engdahl: Every time I ever hear Jeff Fischer speak, I think, wow! Options are awesome, these things are so cool. And as soon as he stops speaking, I’m like, what’s an option? [laughs]
Southwick: Me too. I’m like, OK, so if I think the stock is going to go up, then I want to do… and then everything falls apart. But I think because of the joy that my husband gets out of it, and just the intellectual stimulation, even if he was just breakeven, I’d be like, that’s OK, that’s OK. But supposedly he does well too, so.
All right, Bro, what’s the last one?
Brokamp: That’s it, that was the last one.
Southwick: Oh, that was it. Okay.
Brokamp: Yes. So those are what you should not do. In our next episode, we’re going to cover five things that we think Foolish investors should do. So tune in next week.
Southwick: Well, that’s the show. It’s edited successfully every week by Rick Engdahl. Our email is Answers@Fool.com. For Robert Brokamp, I’m Alison Southwick. Stay Foolish, everybody.
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