How to Become a Sophisticated Investor

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No one doubts the value and importance of investor education and sophistication, but many investors are not really all that sophisticated. Goldman Sachs was scrutinized for marketing complex securities to its investors without telling them that a major hedge fund had taken a short position against these securities. The so-called sophisticated investors lost about $1 billion in this synthetic collateralized debt obligation (CDO).

The SEC investigation of Goldman Sachs has emphasized that even institutions rely on sellers and may be misled just like anyone else. This is particularly, but by no means only, the case for highly complex products, which “you need a PhD in finance to understand”. Indeed, critics at the time commented that the distinction between sophisticated and unsophisticated is artificial or doesn’t even exist, at least not where there is provable negligence and mismanagement.

Nonetheless, education and knowledge are probably the most effective tools for raising returns and lowering risk; and in particular, for avoiding truly disastrous losses. Sophistication, in the sense of learning how to get the best out of your money and from the investment industry, is fundamental. But it does not and should not in any way reduce the responsibility of sellers to make clear what they are promising and to do just that.

In this article, we consider how to ensure that you really and truly understand your investments and don’t overestimate your capabilities and knowledge. Furthermore, it is necessary to make sure that what you know and don’t know are not used against you at some point in the future.

What is a “Sophisticated Investor”?

In the sense used here, we mean someone who has sufficient investing experience and directly relevant knowledge to weigh up the potential risks and benefits of an investment opportunity. In other words, the person genuinely understands what he needs and wants, and what he is getting from the seller.

At a...
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