If you’ve been reading this blog for any decent amount of time you know that my investment style is pretty boring. You won’t find any articles on this site about the hottest new stocks or magically high yielding investments. Instead, you’ll see me promoting low cost funds and figuring out ways to avoid any and all types of fees. But just because my investments aren’t that ‘sexy’ doesn’t mean I don’t want to maximize my returns.
I am always on the lookout for alternative investments like Lending Club or real estate partnerships since those are the types of investments that provide for higher returns. But I’m also a realist and I know that any time you try to achieve higher returns, you’re going to take on additional risk. Right now you can get a guaranteed 3% rate of return on a 5 year Penfed CD, so if someone came and offered me a 4% guaranteed return investment, I would automatically question it.
Since most of my friends and family know I’m a personal finance blogger by night, I’m always hearing stories of what the next great investment is. Whether it’s a hot new Chinese solar company or a complicated options strategy, the range of poor investments are limitless. I love talking finances but some of the things people are doing with their money are just plain right stupid. Most of the time I won’t even bother to inform them of my opinion since I think people learn best through experience. If you’ve already been brainwashed by your money manager into thinking he can get you 5% above average market returns(after his 1-2% fee), you probably won’t be listening to what I have to say no matter how logical it is.
There’s Always Risk
One of my favorite types of investments is the ‘risk free’ kind. I can’t be the only person who has to deal with people claiming their friend has a real estate investment(people aren’t dumb enough to fall for a risk free stock investment anymore) that returns 10% a year and is completely risk free. Risk and return will always have a positive correlation: the higher the return, the more risk you’re going to have to take.
I’m all for making as much money as possible but it’s more important to consider the risk. There are actually two types of risk: compensated and uncompensated. Compensated risk means that if you take that risk you will be rewarded accordingly with higher expected returns. Uncompensated risk is a risk which fails to reward you with more return. So when it comes to investing, it never really makes sense to take an uncompensated risk since you can use diversification to avoid it.
If you invest your entire portfolio in one company, your expected return will be the market average. But what if that company goes out of business and you lose all your money? That’s a huge risk that can be eliminated by diversifying across the entire index with a low cost index fund. You might have some inside knowledge from time to time that will allow you to outperform the market once in a while(if you’re really good) but are you willing to bet on yourself to consistently pick winners? Eventually the market will catch up to you and your returns will revert to the mean.
Even professional money managers aren’t able to consistently pick winning stocks so why on earth would anyone think they can too? I realized that after my first couple stock picks went into the tank and although I still own a couple individual stocks from time to time, I would never invest more than 5-10% of my portfolio in something that has so much uncompensated risk. Mathematically, it just doesn’t make sense.
Market Efficiency is a Factor
Any time I hear about an investment that is returning more than it’s benchmark I know that something is fishy. If CD’s are paying 2-3% interest rates for a 5 year term, you know that anyone who guarantees you more than that is full of crap. Financial markets in the US are pretty damn efficient. So if you go out and buy a share of Coca Cola you know that you’re getting a fair price.
There are very few opportunities available to outperform the stock market but it’s a whole different story when it comes to investments like real estate. Depending on your skill level, you can outperform the market in areas like purchase price, sales price and property management. A good real estate investor will be able to find an under-valued property and rent it out for a 10% cash on cash return with little to no money down or buy a house, flip it and make a nice profit in a very short time period.
Past Performance is a Horrible Predictor of Future Returns
The last thing that people like to point to when assessing validity of an investment is its past returns. “Well since this fund returned 10% over the past 5 years, it must be a good fund, right?” Although it is a bit counter-intuitive, past performance is not useful at all when it comes to picking successful investments. Instead, it’s actually the lowest expense ratio funds that tend to have a strong positive(inverse) correlation with performance. Still confused? Let me break it down for you:
- Expense ratios are an excellent predictor of future performance. The higher the fee, the lower your expected return, while:
- Past performance is a horrible predictor of future performance.
I know this might seem a little counter-intuitive but there have been countless studies over the years that prove these statements.
Now that you’re armed with all of this information, the next time someone comes up to you with the next great investment I fully expect you to grill them and ask them all about the points I’ve laid out here. I don’t think you need to turn down every investment that comes your way but you should understand the risk that goes along with each and every investment. Generally when it comes to investing, if it sounds too good to be true, it probably is.
This article was a little more technical than my average article but it hammers home some really important points. What do you think about taking risk when it comes to your investments? I always make a point of hearing out anyone with an investment opportunity but I often find that they don’t pass ‘my smell test’.
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-Harry @ PF Pro