Lessons from FTX
What we can learn from OTTP's $95-million loss
In 2021, the Ontario Teachers' Pension Plan made a $95-million investment in FTX, a Bahamas-based crypto currency exchange that was founded in 2019. A year later, the investment is worth zero.
For a pension fund that manages $245-billion, making some bad investment decisions is part of process. The fund overall does well and has earned a 9.6% annual return since its inception. With almost 500 investments in its portfolio, it can afford to make some mistakes. The write-down of the FTX investment for didn’t do much harm to the overall returns of the Ontario Teachers’ Pension Plan (OTPP) .
For individual investors, though, a total loss on even one stock can really hurt.
The OTPP/FTX story demonstrates three investment principles that all investors should understand: picking stocks is really hard, diversification is essential, and investing in new businesses is risky.
Picking companies is really hard
OTPP employs a lot of investment professionals, people who are educated in finance and many of whom have years of experience in the business of managing money. They have access to industry experts, they meet with the management teams of the companies they invest in, and they have financial modeling tools at their disposal to analyze a company’s profitability.
If a firm with this kind of expertise can’t get it right, then how do us ordinary investors even stand a chance? We don’t have any of these tools and resources – nor do we have the time. And even if we did, we will still make some wrong decisions.
Related: Why picking stocks is so hard
OTPP has a fiduciary duty to its 333,000 pension plan members and it takes that seriously. That’s why the investment in FTX made up just 0.05% of the money it manages, limiting the damage that this $95-million loss has on the pension fund.
This demonstrates the second important lesson: if you’re going to pick stocks and companies, you need to have enough money to be well-diversified. This means that you hold many investments, and any one investment makes up only a modest portion of your total portfolio. If an investment turns out to be a dud, you’ve made money on your other holdings to offset it.
Let’s say you have $100,000 to invest and buy 10 stocks. If nine of those stock go up by 5% in a year, while one falls by 70% (which is how much Bitcoin has fallen over the past year), you’ll have lost $2,500 over that one-year period. You made $4,500 on the nine good stocks but lost $7,000 on the dud. All it takes is one bad choice to wipe out all of the good stuff. (BTW, owning 20 good stocks and the one dud would result in a gain of $1,250 since the dud is only 5% of your portfolio.)
In reality, most people don't have enough money to properly diversify across stocks.
Real businesses with track records
When I was a stock analyst, I found that the best information to use when analyzing a company was its financial track record. Looking at a minimum of 10 years’ worth of financial information, such as how much money it earned, what kind of profit margins the company had, and how much actual cash it had in the bank, tells a story. You can see that in good times and bad, a company survives. It has shown its resilience.
FTX had no such track record. It’s a new company with little financial information - and the information available to OTPP was useless. (The new CEO described the company as having “…such a complete absence of trustworthy financial information…”). Compounding the issue is the fact that its industry – crypto currency – also has a very short track record. OTPP’s analysts had unreliable financial information, had to make a guess about how the crypto story would unfold, and put too much trust in the people running FTX (people described by the new CEO as “a very small group of inexperienced, unsophisticated and potentially compromised individuals”).
Whether it’s FTX, bitcoin, or the emerging internet companies of the late 1990s, it’s all the same: new businesses, new companies and no track record means high risk.
You and I aren’t in a position to make these bets. Let the super-rich fund the start-ups, the privately-owned companies with little transparency, and emerging inventions that could, in fairness, change the world. We’ll join in once there is a track record.
How to invest
For most of us, using exchange-traded funds to get proper diversification prevents us from making the mistakes that the Ontario Teachers’ Pension Plan made. By taking away decision-making, we avoid choosing the wrong stocks. It also takes the emotion out of our investment decisions; there’s no temptation to get in on the action of a hot stock, or play around in the IPO market.
Related: Do I really need to be in the stock market?
Buy broad-market ETFs that give you exposure of hundreds of companies and hold on until you need the money. Be content with the 8% return that the stock market earns over the long-term. Taking big risks for a more simply isn’t worth it.