Skin in the Game: The Fundamental Question To Ask Yourself Before You Take Advice

The world seems to always give us advice. Friends tell us which Netflix shows to watch, families tell us what job to take, self-help books tell us how to spend our mornings. We get given so much advice that we have to somehow figure out which advice is worth taking.

The main question to ask yourself is: “Does the person advising me have skin in the game?” That is, what kind of losses are exposed to the advisor if this goes wrong? If your friend is telling you to buy bitcoin, you should find out how much money they would lose if bitcoin lost its value – if the answer is zero, you should run in the other direction.

This is precisely what happened on Wall Street, where fund managers got bonuses for wins but paid no penalty if they lost. In turn, they ended up taking high risks with other people’s money, knowing that they had no skin in the game and that taxpayers could rescue any bad decisions.

In contrast, Warren Buffett owns about 16% of the multi-billion dollar fund he manages, so if the fund loses, he loses in a big way.

Nassim Nicholas Taleb, the author of Skin in the Game, suggests we should take note of people who stick up for a truth that makes them unpopular, or people who act in a way that risks ostracism. He writes simply, “Avoid taking advice from someone who gives advice for a living, unless there is a penalty for their advice.”

Want to know another stance on advice-taking? Click here.

The Intelligent Investor: Insights From Benjamin Graham

“Don’t tell me what you think, tell me what you have in your portfolio.”

Nassim Nicholas Taleb

I recently read The Intelligent Investor by the legendary value investor Benjamin Graham. Known as the most complete guide to investing ever written, his wisdom has stood the test of time. His legacy lives on not only in this book, but in his students such as the mighty Warren Buffett.

The book is extensive and can be tough to digest at times, but it was well worth reading and I learned a lot.

One of the key lessons I learned is that you cannot sensibly become an enterprising investor unless you are willing to read a company’s annual report. An enterprising investor is one that picks specific stocks and buys them for a price that they deem is good value. The only way they can do that reliably is by perusing through several years’ worth of annual reports with a fine-toothed comb, looking for information to judge whether the company is undervalued or overvalued in the stock market. Even then they could still be wrong and end up losing money.

The good news is that I can become what’s termed a “defensive investor”. It doesn’t sound nearly as cool, and there’s no longer the possibility of bragging to your friends about picking winning stocks, but it is much less risky and takes much less time. Defensive investors usually buy a combination of low-cost index funds (groups of stocks that follow the entire market such as The Dow Jones Industrial Index or the Standard & Poors 500 Index) and bonds from governments and companies.

I was 15 years old the first time I was introduced to the idea of the stock market in my Statistics class in school. We were asked to go on the Internet and pretend we were investing in some stocks. I looked on the Dow Jones list and I remember just choosing the companies that had the green numbers next to them – the stock price was going up. If a stock price was going up, I could sell the stock a week later and win the competition of getting the highest profit in my class. But I was in for a shock.

The next week, I logged back in to find that not only had I not got the highest profit in the class, I had lost money! Unfortunately this is the reality for many wannabe traders who don’t do their homework.

That formative experience gave me a couple of conclusions – The stock market doesn’t extrapolate well, and I don’t understand the stock market. But there’s no shame in that, very few people do. No person on Earth knows what the market will do next.

One of the biggest lessons in The Intelligent Investor is the importance of not losing money. It takes a lot more time to recoup losses than it does to increase the investment by the same amount. People that lost 90%+ of their money when the dot-com bubble burst in 2000 still would not have been able to break-even over 20 years since. So how can you be in the market as a defensive investor but lose as little as possible?

Graham recommends a combination of bonds and index funds in a 50-50 split. If the investor is feeling bullish (optimistic) about the market, he can go up to a maximum of 75% index funds. If he is feeling bearish (pessimistic), he can increase the bonds proportion up to 75% instead. The diversification of the bonds and having shares in all the companies in an index such as the S & P 500 will shelter the investor from undue losses.

In March 2020 the stock market dropped significantly and the market value of my investments dropped several thousand dollars. With a global pandemic looming and plenty of uncertainty, I took most of my invested money out of the market. I had turned an “unrealized” paper loss into a “realized” loss. This turned out to be a big mistake, as I missed the gains I could have had on the subsequent recovery of the market to an even higher level than before.

The biggest lesson I learned from that experience is that my risk tolerance wasn’t as high as I thought it was, and it had changed over the years as my investment fund got larger. I had sensed this in the back of my mind for months on end, but I didn’t do anything about it because the market was steadily going up at the time.

Another lesson was that the more often I check my investments, the worse decisions I will make. I use a robo-investing app that rebalances my portfolio and gives me the option to automate my contributions to my fund, so there’s no real reason I should be logging in if I don’t need to. Checking investments frequently is the equivalent to appraising your house all the time, even if you don’t plan to ever sell it.

Another important thing to consider is how much money do I need in savings before I put money into investments instead? Money in savings accounts will track the rate of inflation at best, and at worst it could be losing value if inflation rates happen to be high. Over the long-term, money invested will beat the rate of inflation and will be worth more when you eventually decide to use it. This doesn’t mean that all spare money should go into investments. If you are saving for a deposit on a house, it’s better off in a savings account. Emergency funds (12-24 months of expenses) should also be in savings in case of a loss of job or a sudden large expense.

One insight The Intelligent Investor brought to me was that everyone that invests is obsessed with beating the market. But what’s actually important is asking: “Do I have enough money for my life goals?” It can be so easy to get lost in the numbers and forget what you’re actually wanting in life.

Since starting to use a robo-investing app over the last couple of years, I have noticed that it is way more fun to save and invest. Even if (or should I say when?) I end up losing a significant proportion of my portfolio again, I can be grateful in years to come that I took the conscious decision to take responsibility of my finances.