In recent columns I have expressed my deep skepticism regarding the merits of trading “meme” or “Reddit” stocks by retail investors. While the siren song of making a small fortune overnight is tempting, I have cautioned that this type of strategy cannot be deemed “investing” and could risk one’s financial future. Moreover, I proffered the notion that the entire proposition of trading highly volatile stocks should be considered nothing short of legalized gambling.

Last month I warned of the danger of this type of activity that can potentially result in “a permanent loss of capital.” Given the frothy equity markets today and the many stocks trading within extremely wide price bands, investors caught on the wrong side of a trade can easily suffer losses that result in a permanent loss of capital. To illustrate this notion, I would like to cite a recent example of how easy it is, even for seasoned professional money managers, to fall victim to a permanent loss of capital.

Exhibit A: Archegos Capital

For those who do not actively follow the inner workings of the financial markets, they may not be familiar with the recent debacle at Archegos Capital. This particular family office fund (similar to a hedge fund), which at one time is rumored to have had peak assets under management of $20 billion, was embroiled in a high-stakes game of taking concentrated positions in volatile stocks that were performing rather well earlier this year. When the rally in these stocks began to wobble, Archegos was forced to liquidate their investments, causing unprecedented slides in the share prices of their stock holdings. For example, within a few days, the stock of one large media company, Viacom, fell more than 50%. Parenthetically, the S&P 500 index rose slightly over that same period of time.

Because of the speed and severity of the stock price declines, investors in the fund lost their entire investment, which The Wall Street Journal estimated to have been about $8 billion. Moreover, several Wall Street firms that engaged as principal trading counterparties with Archegos have cumulatively lost billions. In a press release last week, Credit Suisse announced that they would likely suffer a loss in excess of $5 billion, as the company was forced to absorb credit losses from their trading activities with the now-bankrupt Archegos fund.

What Went Wrong?

How does an experienced fund manager manage to lose $8 billion in less than 10 days? In this case, the fund manager violated two cardinal rules of investing. With only a handful of stocks in the portfolio, the fund clearly lacked proper diversification. Most equity investors, even those not so seasoned, understand the idea that spreading out one’s risks into a number of different sectors and individual stocks helps mitigate the risk of being wrong about any particular sector or stock. Moreover, the manager exacerbated the high concentration of his portfolio by employing unusually high leverage, i.e., investing with borrowed funds. When one uses leverage to make a large bet that goes awry, the risks of severe negative outcomes are magnified by many multiples.

The manager of the fund, Bill Hwang, was no amateur by any means. He had a well-established track record in the hedge-fund industry. Why he decided to employ such a fraught strategy is the subject of much speculation. But the lessons for investors are quite instructive.

Lessons Learned

Aside from the clear risks of making concentrated bets using extreme leverage, investors should take away the notion that one bad investment strategy can have extremely painful consequences. There are many reasons why an investment goes bad. Sometimes it involves unforeseen corporate management shenanigans including fraudulent behavior. Sometimes it is related to unforeseen external or “black swan” events that can quickly change the risk parameters of a given company or industry. COVID-19 was one of those black swan events that wreaked havoc on the business world, and in some cases, bankrupted companies that were not prepared for an economic shutdown.

But many times, poor results from an investment strategy are easily avoidable. Even when one properly invests in a broad, diversified portfolio of blue-chip stocks, one can still experience periods of negative returns and/or underperformance, as was the case in the first quarter of 2020. But the pandemic was clearly not an event that resulted in a “permanent loss of capital.” In fact, the broader market averages have more than recouped their losses and have already moved well into record high territory.

When ultra-risky investment strategies go bad, there may never be an opportunity to recoup one’s capital. And that can be devastating for those relying on these investments for their retirement or for a large future purpose. Thus, I always recommend not only avoiding high-risk investment strategies, but also taking a sober look at the potential downside of any investment opportunity.

Bottom Line

If an investor is solely focused on the upside of an investment or trading strategy, and ignores the risk of the downside, the results can be devastating. The goal for most of us should be to achieve healthy, realistic returns over the long term and not to try making a quick buck with an ill-advised or untested strategy. By staying focused on the potential risks, and adhering to the core principles of investing, investors should be able to achieve financial goals without putting their nest eggs and their financial futures at stake.

The views presented are those of the authors and should not be construed as personal investment advice or a solicitation to purchase or sell securities referenced in this market commentary. The authors or clients may own stock or sectors discussed. All economic and performance information is historical and not indicative of future results. Any investment involves risk. You should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice. All information is obtained from sources believed to be reliable. However, we do not guarantee the accuracy, adequacy or completeness of any information and are not responsible for any errors or omissions or from the results obtained from the use of such information.

Jonathan D. Caplan, a former Wall Street executive, is president and founder of wealth management firm Caplan Capital Management, Inc., with offices in Highland Park and Hackensack. He holds a BA from Yeshiva University and an MBA in finance from New York University Stern School of Business. You can find other recent investment articles by Jonathan at www.caplancapital.com/blog.