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The Five Minute Rule

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5There’s an old adage in investing that doesn’t get enough appreciation or attention – “If you don’t understand the thesis underlying an investment in five minutes or less, take a pass.” I only recently read it in a summary of a talk given by Vanguard CEO Bill McNabb at the Morningstar Investment Conference in June and the quote is attributed to Richard Ennis of the pension consulting firm Ennis, Knupp.

The idea itself takes fewer than five minutes to understand yet it’s so powerful. For year’s I’ve wanted to fully understand the complicated world of options investing. On the face of it, options aren’t difficult to understand. Call options are the right but not the obligation to buy the underlying stock at a specific strike price. Put options are the right but not the obligation to sell the underlying stock at a specific strike price. Easy.

It’s the strategies, the Greeks, and all the ancillary stuff that I can’t keep straight in my head without a quick refresher from a book. Which is why I have yet to buy or sell a single options contract.

If this rule works for investing, it should work for anything. If there is something you can’t understand in five minutes or less, take a pass. If there’s a loan that is so complicated you can’t figure it out in 5 minutes, pass. If you can’t explain why you should get a negative amortizing option ARM, you shouldn’t get it (it’s ideal for people who have irregular income, but good luck getting one now). If you can’t calculate how much interest you’re paying to a credit card, you shouldn’t accumulate a balance.

Savings accounts make sense to me. CDs make sense to me.

If you think that you don’t understand something because you’re just not smart enough or because you’re not a “money” or a “numbers” person, bullshit. Don’t use that as a crutch. Everyone is smart enough, it’s just a matter of time. It’s like solving a maze or a puzzle, you can do it but it’s just a matter of time. If you give up and sign on the dotted line for something you can’t understand, you’re liable and it’s your life that gets trashed if things turn sour.

The five minute rule is golden.

(Photo: mypouss)

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9 Responses to “The Five Minute Rule”

  1. Emily says:

    If you’ve ever heard Warren Buffet speak, I think you could say he agrees with this. He and Charlie Munger have said frequently that X financial deal was just too complicated for them. They don’t invest in industries they don’t understand either.

    In other words, I guess you can do alright sticking to what you understand and not feel bad about avoiding over complicated stuff.

  2. Miranda says:

    What a great, simple rule! I like the idea that you should understand what you are doing. Whether it’s getting a car loan or trading currencies, you do need to understand what you are doing. After all, those who understand money are more likely to get it to work for them!

  3. billsnider says:

    I have passed on investments using this simple rule without knowing there was just such a thing. It is a natural instinct.

    Thanks for pointing it out.

    Bill Snider

    • Shirley says:

      Long ago I realized that if I didn’t understand something (or the consequences of doing it), I would best off not to do it.

      If it is something really enticing, I will try to learn its workings, but I still want to know the basics of the consequences first.

  4. cubiclegeoff says:

    I agree that anyone can learn pretty much anything, they just need to make an effort. Sometimes having someone you trust explain everything is also helpful, as long as they truly know what they’re talking about.

  5. The question is: How much effort do you put in when you are not sure of the benefits?

    You are right, the option is easy to understand. Proper usage – that’s where time is required.

    How do you suggest deciding whether it’s worthwhile when you do understand the product – but not the specific details of how to use that product.

    For me, options are easily worth the effort. But they are not for everyone.

    Regards

  6. zapeta says:

    As Jim mentions, you’re ultimately responsible for what you sign, so take the time to understand what you are agreeing to. Some topics may require more than 5 minutes to understand but if you still feel uncomfortable with something, get clarification or don’t sign the agreement.

    • poscogrubb says:

      I agree that you shouldn’t sign on to something you don’t understand. In the world of financial tools, that includes a basic understanding of the factors that make your position go up or down.

      If you don’t understand it in 5 minutes, don’t sign on the dotted line.

      HOWEVER, that does NOT mean you should give up and not take more than 5 minutes to learn about it. This happened to me recently: a broker proposed buying into a callable very long term corporate bond with a high interest rate for the first year. Interest in the remaining years was based on the difference between long-term and short-term interest rates of Treasuries–something like that, I think. Despite the nice sounds the broker was making, I had to say no because of my lack of understanding of how interest rates behave. However, I would like to spend up to an hour reading and learning about it. (You have any resources on this topic? Please let me know.)

  7. scdavid says:

    couldn’t agree more with this. You really should be able to use this for more than just investing. Loans, etc come to mind.


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