Before you invest, let us investigate.
Know Your Collateral

Perhaps the most important question you can ask prior to placing capital into an investment is "What is the collateral backing the investment?" The collateral is the asset (or legal rights) that you are left with at the end of the day when all of the other structural and external factors are stripped from the investment.

Generally, investment returns (or the lack thereof) are ultimately derived from the underlying direction or performance of the collateral. Coupled with knowing your position in the "capital stack," knowing the ultimate collateral of your investments makes all the difference in the protection and growth of your wealth.

Paying attention to your collateral keeps you away from investments that have insufficient value or cushion to protect your principal. This seems rather obvious and almost not worth mentioning--save for the many investors and financial planners we encounter who make investments without first considering or understanding that which is ultimately standing behind their investment. They pay attention to the popularity of a name, the income currently being paid, or the prospects of gains should the business succeed, but they ignore the downside risk that could impair or eliminate their capital altogether.

Stock and bond ownership are common investments for which investors often pay more attention to the dividend, interest payment, or appreciation potential instead of the actual assets, businesses, or rights backing their investments.

When an investor buys stock, the stock itself is not the collateral of the investment. The company is the collateral. The stock is simply the vehicle through which an investor owns a percentage of the company. The stock is ultimately collateralized, or "backed", by the strength or weakness of the underlying company. All too often, investors simply watch the price movements of the stock or the latest developments in the news instead of studying the underlying financial health and growth prospects of the company for which the stock was issued.

If a company is financially healthy and performs well, its stock may very well appreciate to reflect higher earnings or earning potential. If a company fails and declares bankruptcy, and if its liabilities exceed its assets, its stock value (and thus, your capital) will be wiped out entirely.

At JRW, prior to making a recommendation, we look at the financial strength of that which actually backs your investments to consider the probable downsides that may face a particular investment and to determine what level of cushion or excess value is in place to protect your capital. We also look at how that investment might respond to certain economic shocks that could affect the overall market or the particular investment. If an investment is overleveraged, operating with very thin margins, or in an industry or market that may be tenuously overdependent on a healthy economy (and thus, at greater risk in a recessionary environment), we avoid the investment altogether since the risks outweigh the reward potential. 

Note that this collateral analysis comes long before we even so much as consider the potential for an investment's income or growth. If an investment cannot pass the collateral test, we move on, disregarding the upside potential altogether. Holding to the principles of wealth management , we must take guarding principal seriously if we are to grow wealth over the long run. 

In addition to protecting capital from poor collateral on a direct investment level (the trees), knowing your collateral will allow you to also see how an entire collateral category might impact your portfolio (the forest). Armed with this knowledge, you are able to better understand how macroeconomic factors may impact your investments, which will help you take advantage of economic swings (inflation, deflation, interest rate fluctuations, etc.), and maintain a much broader diversification across multiple collateral categories. 

Knowing your investment collateral leads to lower downside risk, higher potential returns, a wider array of investment liquidity, and the ability to take advantage of larger market trends. An investment is only as good as its collateral; therefore, understanding the investment-specific collateral and the relevant collateral types is an absolute must prior to investing. 

This Kind of Collateral

Or This Kind

But Not This Kind

Written By: Joshua Ungerecht

Collateral, Collateral Types, Principles of Wealth Management, Value Investing