Investing at its very core is simple. It’s all about risk and return. How much of an incremental dollar are you willing to risk to gain a dollar.
Warren Buffett eloquently simplifies this even further with this advice on investing:
Rule 1: Don’t lose money
Rule 2. Don’t forget rule number 1
However, along the way we have made investing beyond complicated. Evidence of this was recently cemented in my mind with a fascinating article about a guy that lost $200 million for the bank he worked for.
The story is fascinating in itself. However, what was fascinating to me was the fact that you had a physics Ph.D that was designing financial products with obvious risks of over $100 million.
Understand that I am a finance nerd at my deepest core. I sold my hedge fund in early 2008 and haven’t looked back since. I will be the first to tell you that a Physics Ph.D could design anything he wanted and there would be absolutely no way I could understand what he or she is doing.
What is Risk Anyway?
In the first day of Finance 301 they tell you that risk is standard deviation. Meaning, how returns are distributed. You have to agree with this principle to understand anything you are about to learn in this class. Because the next thing you learn is about expected returns. An expected return is the weighted average of the likely profits in each asset class.
Here is the formula for the expected return:
Note, the oversized standard deviation symbol which is the fulcrum of the formula.
The fallacy of standard deviation as a risk measurement
Not to get too picky but standard deviation is simply variance squared. Variance is the actual dispersion in returns. There are other fancy terms statisticians, physics professional and finance professors have come up with like: mean absolute deviation, target semi variance, Chebyshev’s Inequality, and well you get the idea.
Here is the problem with all of the above ratios and the Sharpe ratio which we will get to later:
None of the above statistical measures measure how much money you are losing.
That’s crazy right?
Risk is defined by how different the returns are…not losing money.
This is an absolute crazy definition of risk.
This Christmas I let my 7-year old daughter carry her $20 in Christmas money around herself (read: risk). Henceforth, it was lost. When a stock goes to $0 – this is a real risk! Note, I’ve never seen a piece of real estate go to zero – but we will get to that later.
Why the Sharpe ratio continues to fail stock and bond market investors
The Sharpe ratio is Wall Street’s favorite ratio for risk and return. Why?
Because it’s a very simple measure that measures excess return for every level of risk. Note, you will see that pesky standard deviation metric we talked about earlier.
Here is the formula for the Sharpe ratio:
Sharpe ratio = [(mean return) – (risk-free return)] / standard deviation of return
Instead of talking about how ridiculous this measure is and pointing out that this is simply a measure that Wall Street invented to sell you more mutual funds let me share with you a very personal story.
This summer I visited a country in sub-Saharan Africa and was pretty surprised to see how many banks were there, and how much they could afford on advertising. I was really surprised when I talked to locals about how the banks operate there. The banks charge to actually make a deposit (1%) and then they charge when you make a withdraw (1%). They also charge around 7-10% for real estate loans. Now for the worst part: a couple of years later, all the banks failed and confiscated everyone’s deposits.
This is RISK.
Risk = Losing Money
If Warren Buffett can simplify it, I can as well.
The problem is that we have let Wall Street define risk for us.
Importance of Cash-Flow and Alternative Investments
Stop letting Wall Street define risk for you. They don’t understand it themselves. Look at their performance during the last economic crisis. They all had to receive government support (corporate welfare). Why should they have any creditability with defining risk? As Charlie Munger puts it:
“It is difficult to get a man to understand something, when his salary depends upon his not understanding it!”
Timber has been a favorite alternative investment of mine for over a decade now. The best part about timber is you literally don’t do anything. Every year the tree’s grow you make 2-4%, assuming constant lumber prices. The best part is that when lumber matures for harvesting you don’t have to sell. You can wait until you are satisfied with current lumber prices to sell. Typically, lumber prices are correlated with the housing market. However, they are not correlated with anything related to the stock and bond markets.
Further reading: http://alternativeinvestmentcoach.com/investing-in-timber/
I always joke with my friends that I don’t invest in collectibles but my wife sure does! My mom and stepdad were able to retire early trading gold and diamonds. This is not complicated so don’t make it out to be. All they did was go to flea markets and find people that needed cash ASAP. They would buy gold coins and diamond rings at heavily discounted prices. They would then get a booth at a gold and jewelry show once a year and sell everything at 2-5x what they paid for it.
Further reading: http://alternativeinvestmentcoach.com/invest-in-diamonds/
This is the alternative asset class I focus on personally. Real estate takes a lot less capital than one typically thinks. For instance, there is a hotel shortage in my town and a major event coming. As a joke, I listed my house on Airbnb.com for $550 a night and a 7-week minimum. I ended up being inundated with offers. This cost me no extra money. I have also bought investment properties with no cash out of pocket and receive very nice rent checks. Rent increases while the loan payments are locked in for several years hedging inflation.
Further reading: http://alternativeinvestmentcoach.com/investing-in-rental-properties/
Alternative investing is a lot cheaper to get into than investing in stocks, bonds and mutual funds. Additionally, the returns are generally greater and you have more control over these investments, which in my opinion provides a higher safety net because of this control. In summary, don’t let others define risk for you – especially if they are trying to sell you something. Low risk high return investments aren’t a myth – they just require education.
Further reading: http://alternativeinvestmentcoach.com/low-risk-investments/