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Halloween Horror Stories: The Poisoned Apple

We all know the scariest stories are true stories, so gather ’round kiddies as I tell a tale of investing horror that will haunt your dreams and send shivers through your portfolio.

It all started innocently enough as a young California man named Andy Zaky discovered a knack for forecasting Apple‘s (NASDAQ: AAPL.US) quarterly earnings as well as significant moves in the company’s shares. His fame as an Apple oracle provided a strong following for his investment advice newsletter titled Bullish Cross.

While Bullish Cross discussed other investment ideas, the real star of the show was Apple and the site even developed a trading portfolio. In this, Zaky would buy and sell Apple shares as well as options on the shares. Things were going so well that Zaky started an Apple-only hedge fund that attracted at least $10.5 million from investors.

Fly too high…

And that’s when things went wrong. Zaky’s magic touch seems to have abandoned him in 2012 as he not only missed some big moves in the shares, but bet heavily in the wrong direction on more than one occasion.

The death knell came in November 2012 when the hedge fund’s liabilities — accumulated by taking leveraged bets on Apple’s shares — exceeded the funds capital. Zaky had lost all of his investors’ money.

Now, the only people that can invest in hedge funds are so-called sophisticated investors — those with the money and knowledge to assume the risks that come with the big bets a hedge fund might make — so while some of them lost large amounts of money by betting on Zaky’s Apple expertise, it wouldn’t have been crippling.

Collateral damage

Unfortunately, you didn’t have to be a sophisticated investor to subscribe to Zaky’s newsletter, and many normal folks like you and me took a hard fall on this Apple gambit. Some lost their retirement nest eggs, some lost their marriages and some considered suicide.

Gaining immense wealth from the market is the dream of every investor — just as losing it all is the nightmare scenario we all share — so we can empathise with those lured in by Zaky’s apparent prescience. But there are some very important lessons we can take away from this tragedy to make sure the same fate doesn’t befall our portfolios.

The moral

First, diversity is your friend. Putting too much of your money in a single company exposes you to immense risk. The future is unknown and once-great companies are called that for a reason. Anyone that invested through the global financial crisis knows venerable institutions like banks are just that until they aren’t. Spreading your investments across companies and industries can protect you from the sometimes violent twists of fate.

Second, leverage is your enemy. We all know the markets are unpredictable and lawyers always make us say investments in the market can decrease in value. At The Motley Fool, we recommend not investing any money you will need in the next three years in the market because it is volatile in the short term and having to cash out at the wrong time can be damaging to your portfolio’s returns. However, as long as you aren’t borrowing, you can only lose what you put in. When you add leverage to the equation, things can get significantly worse. One could point to the banks again, but that seems excessive.

Third, invest with discipline. Knowing your limits and how much risk you are willing to take will help you set rules on how you invest so that you can craft a portfolio that allows you to sleep at night. One mistake Zaky made was breaking his investment rules in a desperate attempt to make up for losses. Investors won’t win every time, but if you maintain discipline you should be able to limit your losses.

As I said above, disaster can befall any company but those with good business models and competitive advantages like  strong brands generally have the odds in their favour. Apple, after all, has seen its shares slip from their highs, but the company continues to sell lots and lots of iPhones and pay its shareholders a nice dividend.

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> Nate does not own shares of Apple, but the Motley Fool does.