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Never Invest in Something You Cannot Understand

One lesson from Warren Buffett has served me particularly well over the years:

“Never invest in a business you cannot understand.”

Of course, this can be extended across much of the financial world.  As a general rule I adhere to “never invest in something you cannot understand”. I bring this up as the Chinese stock market collapses.  Their stock market has cratered 40%+ in just a matter of weeks. It’s a truly breathtaking collapse. And it reminds me of my own personal experience in Chinese stocks during the 2007 bubble.

In my book I go into some detail about the story, but the short version is that I shorted the Chinese stock market bubble without fully understanding what was going on in the market. At the time there was a discrepancy between mainland China shares and Hang Seng traded shares and the markets traded differently due to a government induced arbitrage that was occurring between the two.  I had literally timed the Shanghai peak to the day, but the Hang Seng market continued to trade higher. And so I was caught short in a vicious bubble during which I rode a 20% rally higher which eventually unwound entirely and left me relatively unscathed, but emotionally scarred.

What I learned from this was that the Chinese stock market is a big black box. It is a market I have found to be nearly impossible to understand. I don’t know exactly why this is. It’s probably some combo of government corruption, illiquid markets and insufficient public data.  But the lesson is simple – when in doubt keep things simple and stick to things you can understand fairly well.

Working from an operational perspective I think it’s so important to understand the world for what it is. Of course, we can’t understand all the moving parts of the markets, but we can substantially reduce risks by sticking to our core competencies and avoiding things we know we don’t understand well.  It will be tempting to diversify so much that you have exposure to lots of different markets and instruments. But often times this just results in diworsification.  Your portfolio can be adequately diversified without being excessively complex to the point where you’re actually adding potential risks to it.  Never invest in something you cannot understand.