In my previous couple of columns, we have discussed that it is no wonder why so many people lose when they try to invest. The reason is that they naturally assume that because they are good at medicine, law, accounting, or running a business, or whatever, their expertise will automatically transfer to the investment area they are evaluating. To become an expert in any field of investment requires as much time and energy as it did for any of these types of people to become doctors, lawyers, accountants or business owners in the first place.
The casino in Las Vegas did not just pick a game of chance and make up the betting odds. It did enormous amounts of statistical research to identify its exposure so it could restructure the rules. Therefore, the main function of becoming a prudent investor is learning what questions to ask and what investment parameters you must have present in your investment structure to succeed.
I would like to illustrate this by looking at someone who wants to invest in investment-grade diamonds. Granted, this is not a traditional investment for many people, but it can easily demonstrate today’s point.
Let us say this person did his homework and learned about investing in investment-grade diamonds before starting out. He learned all about the four “C’s” of diamond investing (carat size, color, clarity and cut) and that only diamonds one carat and larger are considered true investment grade. He also learned that the diamond’s color must be between “D” and “H” to be considered investment grade; with the clarity ranging between flawless and no less than VVS2. Additionally, he learned that the G.I.A. Laboratories must have recently certified all stones. These basics are covered in most investment diamond books, so next the buyer goes to a diamond broker.
The problem with selecting a diamond broker as an adviser is that he is also a dealer selling his own inventory. Unfortunately, he has to buy all kinds of diamonds (good and bad) when he gets his inventory from DeBeers (the diamond cartel). Obviously, he does not throw away the bad ones and sell only the good ones.
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Nevertheless, if this were you, you might say because you have done your research, you know how to pick the good stones from the bad. You are all set because you know the four “C’s” and have outlined your investment parameters. OK, let’s see.
One of the most interesting things about diamonds is they are not particularly pretty until they are cut. Nature controlled three of the four “C’s” (color, clarity, and carat size) 20 million years ago when the diamond was created. However, only the cutting process can release a diamond’s inner beauty. Additionally, strangely enough, the best cutting design, the one that makes the diamond the brightest and most colorful, wastes most of the diamond’s original rough material.
Because diamond cutters pay for the rough stone by weight and sell it as a finished cut stone (by weight), there is a natural tendency to leave as much of the rough in the finished stone as possible. However, the prettiest (most valuable) stones waste the most rough material. Therefore, the price has to be adjusted downward if the cutter tries to cheat and leave something on the stone that should have been cut away.
Now armed with your four “C’s” as parameters, you are sitting with your diamond broker. To play it safe, you firmly state, “I want to buy at least a G.I.A.-certified one carat, ‘D,’ flawless, well-cut diamond.” The diamond broker shows you a stone certified as a 1.00 carat, “D” (color), flawless (clarity) stone. It is exactly what you requested.
Let’s assume you are smart enough to know that most sophisticated diamond investors want to buy stones only at least three to five points over the one carat size (1.03-1.05) and will discount heavily for a 1.00 exact size. This is because in the event the stone were to get scratched it could be re-polished and not risk going below the crucial one carat weight parameter.
Therefore, you say, “No, this won’t do, I want at least a 1.03 carat or bigger!” The diamond dealer immediately shows you another stone. This new stone is a 1.03-carat diamond with the exact same qualities previously requested. However, the certificate reflects the diamond has a 75 percent table (the percentage of the top surface of the stone to its diameter). Again, let s assume you are knowledgeable enough to say, “No, this isn’t good enough, either. I want a table between 58-65 percent.” The reason is that if a diamond’s table is too broad, the stone will not disperse light properly and will be heavily discounted when you later attempt to sell it.
The diamond dealer says, “OK, you don’t want a 75 percent table. How about this beautiful stone?” This time the stone has everything right including a 62 percent table, except the certificate denotes the stone has a strong blue fluorescence, also a significant discounting factor.
This game will go on until you are satisfied with a stone and buy it. It will not be until you try to sell your stone for a profit that you will find out whether you asked enough of the right questions.
Profits are made on most investments when you buy them, not when you sell. If you bought the right thing at a good price, you will usually do all right. Additionally, remember never to rely on a broker who profits from what they sell you as an adviser.