Saturday, January 14, 2012

Investment Nonsense

The Investment Risk/Reward Triangle
On the weekends many radio stations offer a set of infomercials often about health or investments.  Much of what these hosts say is absolute nonsense.   For example,  today I was driving to the gym and heard one Sacramento station investment advisor claim he had figured out a way to get away from the "traditional tradeoff between risk and return."

All investments involve uncertainty.  If I invest in a stock or a piece or real estate or a work of art - will the value increase or decrease?   Generally speaking, investors demand a "risk premium" for investments that involve a higher degree of risk.  Thus, in situations like a new business, investors demand a higher rate of return than in an established and well understood business with a long history.

The diagram at the right is a good conceptual tool to explain how this works.   Think of the diagram as a bucket for projected returns.   If you put $1 into the bucket you have a chance of increasing the value of that dollar or losing it.   The two axes of the picture (horizontal and vertical) represent the dynamics of investments.  The Horizontal Axis represents the relative security of an investment.  Keep it in the green zone and you will get the expected rate of return.  Put it in the red and you will lose it.   In reality there are very few purely safe investments, even when you give up return.   The Vertical Axis represents rate of return.  At the bottom of the axis you can expect very little return but relative surety that you will get your money back; at the top a very large return.   What the diagram suggests is that if you want a very high rate of return, you have to be willing to expect that your investment will not pay off, a large percentage of the time.

The "guru's" magic bullet was time.   He yammered on that by laddering maturities you can increase yield without risk.  Well duh - but don't be so sure.  Any competent professional always includes time as one of the variables on risk.  The problem is solving the time part of the risk equation is especially complex right now.

At the right you can see what most people would call a normal yield curve - the yield increases as you stretch out to a longer maturity (thanks Investopedia!)    Note - yield curves can do all sorts of strange things including flattening (where the amount of money you receive for an investment does not vary based on the time of investment) or even inverting (where you get a higher yield for a shorter maturity).

A key challenge in today's environment is your expectations of inflation.   For the last several years the premium given to longer investments has been pretty modest.  So for example, the current returns on Treasuries give you .1% for a month and 2.91% for 30 years.    But the risk that the 30 year investor pays is huge.  If inflation begins to rear its head at all - the dollars you will get paid back with will be worth a lot less than the ones you paid in - so even though you will be getting a bit less than 3% on your investment to maturity - the value of those dollars will be less.

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