Many investors like to follow what billionaires are buying and selling, and why not? After all, some of these people are the most successful investors in the world, so they must know what they're doing. While this may indeed be the case, just because a billionaire makes an investment doesn't mean that you should as well.
Here are a few things to keep in mind next time you read a headline about a stock Bill Ackman, Carl Icahn, or any of their fellow billionaires bought.
Billionaires can take risks you can't
One reason to be very cautious when following the lead of billionaire investors is that they can afford to take risks that you can't.
For example, many high-profile investors, including Bill Ackman, Bruce Berkowitz, and Carl Icahn, have substantial positions in Fannie Mae (NASDAQOTH:FNMA) and/or Freddie Mac (NASDAQOTH:FMCC). It's fair to assume that these investors see a favorable risk/reward ratio here. Ackman has done thorough analysis of both companies and has concluded that if some of the profits were to be returned to shareholders, rather than being swept up by the government, the agencies' stock price could increase tenfold or more.
However, as I've written before, that's a very big "if" at this point. And while I believe Fannie and Freddie's shareholders should get paid, it doesn't mean they will. I actually think the stock price is much more likely to drop to zero due to either an unfavorable legal decision or a complete unwinding of the companies themselves.
So if some of the agencies' profits are returned to shareholders, Ackman's roughly 11% stake in both agencies could easily be worth $5 billion or more. However, if the share price goes to zero and his investment is wiped out, he stands to lose about $500 million -- approximately the current market value of his shares. This is a significant amount of money, but when you have nearly $20 billion in assets under management, you can afford to take risks like that.
So make sure you understand the risks associated with a billionaire's investment before you decide to jump in, and make sure you can afford to take the risk as well.
They also have more influence
Have you ever bought a stock and then obtained a seat or two on the company's board? Probably not. Billionaires have a lot of money to throw around, and by acquiring substantial positions in companies' stock, "activist" investors can gain some control over those companies.
One great example is Carl Icahn, whose investments have often led representatives of his choosing to be placed on companies' boards of directors. Icahn has done this many times, with companies such as eBay (NASDAQ:EBAY), Herbalife (NYSE:HLF), and Chesapeake Energy (NYSE:CHK), just to name a few.
The point here is that some billionaires have the luxury of investing in companies even if they believe the current management team isn't doing the best possible job. You don't have this type of influence, so before you follow a billionaire into an investment, make sure you like the company's potential just the way it is.
And they can sometimes get deals you could never get
Because of the sheer amount of money they have, billionaires can sometimes get investments you don't have access to. One great example of this took place in 2011 with perhaps the most famous investor of all.
News headlines indicated that Warren Buffett was investing $5 billion in Bank of America (NYSE:BAC). However, it turns out Buffett didn't simply buy common shares, or even preferred stock, like you or I would.
Instead, Buffett was issued special preferred shares that paid him $300 million in annual dividends (a 6% annual yield) and were redeemable at a 5% premium. Additionally, he was issued warrants to buy 700 million common shares of Bank of America at just $7.14 each any time before 2021. So far, the warrants alone are worth over $6 billion and could be worth much more by the time they reach maturity. This is a deal that average investors simply could not have gotten.
So, just because you hear a billionaire is "investing" in a certain company doesn't mean they are simply buying shares of stock. Make sure you read the fine print before you decide to follow their lead.
For the most part, billionaire investors know what they're doing. And many of the stocks they buy make a lot of sense as investments -- to them. Just be aware of these special advantages billionaires have that you don't, and ask yourself if any of them apply to the stock you're considering before you decide to copy their strategy.
Matthew Frankel owns shares of Bank of America and eBay. The Motley Fool recommends Bank of America and eBay. The Motley Fool owns shares of Bank of America and eBay. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.