My Sickening Investment Decision
Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I probably could feign ignorance in hindsight but truth is I knew exactly what I was doing. I knew the risks in theory; I just didn’t think they were real enough to affect me. You see, I was on a roll, unstoppable and I was going to make a mint on this directional bet.
I’d been an investor for about five years at the time and was just learning about the amazing leveraging capabilities of call options. But this story started even more harmlessly and at first it didn’t even involve options. I saw a dislocation in the market and I was going to exploit it.
After a long hard battle, Rio Tinto (NYSE: RIO) had won the bidding for aluminum producer Alcan after significantly outbidding Alcoa (NYSE: AA). However, as the deal went through the approval process concerns began to develop that it would unravel as the financial markets were beginning to become uneasy. Rio needed to secure the debt funding and that was a lot to ask given the market conditions. This caused Alcan’s stock to fall a full $10 a share below Rio’s all cash offer price. I couldn’t see how Rio would abandon the deal so I bought 100 shares of Alcan which carried a near five figure price tag. For some that might not seem like a lot, but it was about 20% of my portfolio at the time and I’m sure I probably even used margin to close any gap.
As luck would have it, I was right and the deal went through and I made a rather quick thousand bucks. About the same time I thought that Alcoa might now become a takeover target and decided to buy calls on their shares. I didn’t have a clue if the company was fundamentally sound, all I knew is that they made a failed bid for Alcan and if you can’t beat them then you better join them. Well, Alcoa’s options moved around violently and when they were about half the value I paid for them I decided to double down on the position. Funny thing happened, they went up in value so I sold and I made another six hundred bucks.
As the financial crisis began to come to a head, I was ready to follow the wisdom of Warren Buffett and be greedy when others were being fearful. That’s what I thought I was doing when I bet on the Rio Tinto-Alcan deal going through and that’s what I was going to do now. This time, my eyes were firmly fixed on the financial sector. This was my chance to take my portfolio to another level.
I saw how the government had not let Bear Stearns fail but instead let them be sold to JPMorgan (NYSE: JPM) for $10 a share, up from the $2 they’d previously offered. So, I thought it was a reasonable assumption that Lehman Brothers would be saved as well and probably at a much higher price. They were no Bear Stearns, they’d just hit a rough patch. So what did I do, say it with me, I bought calls and not just a few calls but a whole lot of out-of-the-money calls. I didn’t just do this with Lehman Brothers but I bought calls and shares of mortgage REIT Thornburg Mortgage as well as doubling down again and again in the likes of Wachovia and Washington Mutual. Investors were being fearful and I was being greedy.
You know how that story ended. I lost a sickening amount of money. Both Lehman and Thornburg went bankrupt while Wells Fargo (NYSE: WFC) and JPMorgan picked up Wachovia and WaMu. I knew that there were risks, but I didn’t think that they were real. However, that expensive education taught me two very real lessons that have stuck with me: Know what you are buying and know your allocation.
Take my bet on Thornburg, having been invested in mortgage REIT Anally Capital (NYSE: NLY) for years I was familiar with the mREIT business model but I didn’t realize that Anally’s enduring competitive advantage would be their conservatism in only investing in government backed mortgages. Thornburg invested in jumbo and super jumbo adjustable rate mortgages which were above the limits that Fannie Mae or Freddie Mac would purchase. Because of this Thornburg had a liquidity risk that Anally didn’t have.
My misunderstanding of both Wachovia and Washington Mutual caused me to look past their risker mortgage lending practices. Both JPMorgan and Wells Fargo are known for their conservative managements and fortress like balance sheets. Wachovia and WaMu were more concerned with rapidly expanding their banking empire. If I simply knew what I owned and wasn’t tantalized by the yield or the upside I probably wouldn’t have made those trades.
I’d also not have made those trades if I was more watchful of my allocation. I bet big on Alcoa as their shares were trading at over $30 each when I made my big bet on their calls. While I was risking just a few thousand dollars in capital, on a look through basis it was more like 20% of my portfolio. The same goes for my Lehman bet, while it was just a few thousand dollars of my hard earned capital, it was a gut wrenching amount to lose on a percentage basis. I wouldn’t have just characterized my position as being overweight financials, I was obese.
After the financial crisis I swore off both financial stocks and call options until I learned how to invest with instead of trade in both. I also have paid strict attention to allocation and for me the rule is to not allow any one position to consume more than 10% of my capital. It took me a while, but I have learned how to invest better. By taking the time and taking control I’m now firmly on the path toward financial freedom.
latimerburned owns shares of Annaly Capital Management and has an options position in Wells Fargo. The Motley Fool owns shares of JPMorgan Chase & Co., Annaly Capital Management, and Wells Fargo & Company and has the following options: short OCT 2012 $33.00 puts on Wells Fargo & Company and short OCT 2012 $36.00 calls on Wells Fargo & Company. Motley Fool newsletter services recommend Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.