The biggest story in baseball this spring was the scandal surrounding steroids and other performance-enhancing drugs: several players were caught using artificial and illegal substances to add some extra muscle to their abilities. Many of them have now fallen on hard times, often coupled with ill health. The Yankees’ slugger Jason Giambi, for instance, a onetime Most Valuable Player who has admitted to repeated steroid use, has been relegated to the bench because he can no longer hit for power.
|Relying on a fad may only boost performance in the short term|
That seems to be the case in many walks of life: relying on any type of dodgy fad can result in boosting your performance in the short term, but the ill effects can be more long-lasting and devastating. We’ve certainly seen it many times in the world of investing, when the search for ever-larger returns has led investors down paths that they have come to regret in the morning.
For a time in the 1980s, limited partnerships were all the rage among certain classes of investors; they allowed people to invest in privately held business ranging from oil and gas and real estate to cattle feeding. But declines in real estate and oil prices—combined with changes to the tax code that removed one of their most attractive aspects—basically put an end to the limited partnership market. By the end of the decade, most of these highly illiquid investments had actually lost money.
After the limited partnerships faded away, derivatives—investment instruments peeled off and reassembled from other securities, such as collateralized mortgage obligations—became the hot instrument. Derivatives purported to give investors a more flexible way to manage risk, but they ended up destroying an awful lot of hefty portfolios. In the largest public bankruptcy in U.S. history, Orange County, California, lost $1.7 billion from its derivative investments before going belly-up in 1994.
And then, of course, there was investing in dot-coms in the late 1990s. By the year 2000, Priceline.com, which sold discounted airline tickets, had a higher market cap than United, Delta and American Airlines combined. After peaking at 165, Priceline’s share price dropped all the way to 1.05, losing over 99 percent of its value in less than two years. And Priceline was hardly the only loser in the bunch. Plenty of other high-tech stocks, like TheGlobe.com and 3DO, hit it big then went completely out of business within a few years.
Several investment instruments that are popular today give off similar steroid-like impressions. Basically, any investment that promises enormous future gains based on past performance should be treated skeptically. If the investment is based more on heady euphoria than rational thought, be careful. Here are a few of the popular investments of today that investors should be particularly cautious about:
Hedge funds. These high-powered funds market themselves to high-net-worth individuals, in part because of their exclusivity, in part because the fund managers, free from regulatory oversight, can make sizable investments in a wide variety of assets. Hedge funds can be long or short on stock, commodities, real estate, and many other types of investments. But there’s little evidence that these high-risk vehicles perform much better than simple index funds. Forbes columnist David Dreman found that hedge funds, once you deducted their sizable fees, returned 13.4% annually from 1993 to 1998—at a time that the S&P 500 was going up 19.9% a year.
Real Estate. Although real estate has been a strong investment in the past, many believe we are in the midst of a bubble. No less than Warren Buffett has said he expects a correction in the real estate market. “Certainly at the high end of the real estate market in
some areas, you’ve seen extraordinary movement,” Buffett says. “Residential housing has different behavioral characteristics, simply because people live there. But when you get prices increasing faster than the underlying costs, sometimes there can be pretty serious consequences.”
Commodities. Commodities contracts can be an enticing investment, because their low correlation with other asset classes provides diversification, and because it’s often reassuring to own things, whether it’s gold or grain or oil. But commodities contracts are incredibly risky. Consider this: Although gold is widely perceived as vital to the world’s economic situation, its value relies almost totally on its status as a precious metal. It is estimated that there is 50 times as much gold in circulation now than is required for all industrial uses, including jewelry. A collapse in gold prices could reduce its value to virtually nothing.