Everyone wants to earn a “good” rate of return on their invested capital. But what does this mean? Returns can only be good or bad compared to other investments that have similar risk. A good return for a bond is different than a good return for a stock, which is different than a good return for real estate and so on. So the question to ask first is: Can I earn a better rate of return on my money while taking less risk? Anything that offers better returns while taking on less risk is said to offer better “risk-adjusted returns”. The key is focusing on risk-adjusted returns rather than just returns. In fact, understanding the risks of an investment is much more important than knowing the rate of return that is being promised.
Main takeaway: Returns shouldn’t be judged in isolation because you always have to look at the amount of risk you’re taking. A “good” rate of return depends on what the investment is and the possibility that it could go poorly.
When you purchase a stock or bond, you own something much more than a flashing red or green ticker. A stock represents ownership in a company. As a shareholder, you have a claim on that company’s assets and earnings and are entitled to receive dividends. A bond is a debt investment where an investor loans a company money. In return, for a defined period of time, the company pays the investor a rate of interest that is fixed. Companies must pay their lenders before they can pay their stockholders. For this reason, bonds are often considered less risky than stocks. (For more on this, see “What is riskier – stocks or bonds?”)
Main takeaway: A stock represents partial ownership of a company whereas a bond represents a loan to the company.
Asking this question is like asking: How long is a piece of string? It depends. Many people think that bonds are inherently less risky than stocks. We understand why people may think that way, but it’s just not so. The riskiness of a security is ultimately determined by the price that you pay compared to the value that you receive.
If you could buy all of the stock in Coca Cola for just $10, it would be an unbelievably safe investment – the company earns many times that amount every second. Alternatively, if you bought a bond from one of the most creditworthy companies in the world for ten times its principal value, it would be a very risky investment. These are extreme examples, but the conclusion is the same in all investments: Whether you’re buying a stock or a bond, the risk is ultimately determined by the price that you pay.
Main takeaway: Neither stocks nor bonds are inherently more or less risky than the other. Risk is a function of the price you pay compared to the value you receive. Overpaying for any investment, be it a stock or a bond, is a risky investment decision.
Not necessarily. In fact, all other things being equal, an investment can often be more risky if it pays a yield. Consider the following example. There are two funds that invest in real estate. The first pays a yield and distributes all of its available cash to investors. The second pays no yield and holds on to the cash that comes from the properties. One day, a recession hits and real estate properties start making less money. Both funds still have to pay for expenses such as interest on debt and capital expenditures on the property even though revenues are down. The problem for the first fund is that it has distributed all of its cash to its investors and will struggle to pay its expenses now that revenues are down! There is increased risk that the first fund will let the properties degrade or, worse, default on its debt. The second fund, however, is sitting on a pile of cash because it paid no yield. When a company or a fund pays a yield, it leaves less cash on hand to protect investors from catastrophe.
Main takeaway: Investments with a yield are not always safer investments. In fact, when adversity strikes, investments with no yield are often in much better shape because they haven’t depleted all of their cash.
Despite the countless efforts of brilliant investors and academics throughout history, the unfortunate fact is that no one has been able to develop a measurement system for risk. There is good reason for this. Risk is multifaceted and contains many different elements, most of which are qualitative. How do you measure happiness? How do you measure success? You could try, but you probably wouldn’t want to wager your money on whatever measurement you come up with.
The best way to evaluate the riskiness of an investment is to understand how it makes money and does not lose money. This process takes time, energy and education.
Main takeaway: Unfortunately, there is no measurement that encapsulates the different dimensions of risk. Investors must put in the time and energy necessary to understand how investments work.
This is one of the most difficult questions to answer. It’s also one of the most important. The challenge for investors is that the answer usually comes from people in the investing industry – like ourselves – who have a vested interest. With that in mind, here is our (admittedly biased) view.
First, the best people to trust are those that have a financial incentive to align their interests with yours. If an investment professional gets paid a commission for recommending investment products to you, or for turning over the investments in your portfolio, it is not exactly a great start. Second, since you should never blindly trust anyone, the person to trust should be able to explain the reasons behind investment decisions and how the investments actually work. The analogy we use is that you are the CEO and your investment professional is your Chief Investment Officer – as CEO, you should understand everything that your employee says, even if you can’t carry out the tasks yourself. And finally, you should trust someone that invests his or her own money in the same investments that they show to you. If an investment professional can eat their own cooking, so to speak, it’s worth sitting at the restaurant.
Main takeaway: Investment professionals who (i) institute best practices when it comes to their own compensation, (ii) explain why and how investments work, and (iii) invest alongside you are probably more trustworthy than those who don’t.
To know what an appropriate management fee is for an investment, you must understand the strategy being employed and find out whether you can get the same thing for cheaper elsewhere.
In an ideal world, management fees should be based on the amount of value being added by the people managing the investments and the difficulty of executing the strategy. The industry norm today is not ideal. Typically, the level of management fees depends on the structure of an investment, like whether you are buying an exchange-traded fund (ETF), a mutual fund, or a so-called “hedge fund”. The management fees for these different structures can range from 0.30% to over 3.0%, even if they do the exact same thing.
As a rule of thumb, investors should not pay high prices for returns that are dictated by the ebbs and flows of the market, like you would find in a highly diversified portfolio of publicly-traded stocks. This strategy is best pursued in a low-fee ETF because the investment manager cannot add much value and executing the strategy is relatively simple. On the other hand, investments that require high levels of manager expertise, such as distressed investing and arbitrage strategies, can only be accessed within higher-end fee structures.
Main takeaway: The “appropriate” level of investment management fees depends on how much value an investment manager is adding, the complexity of executing the strategy and whether it is possible to get the same strategy and level of execution for less fees.
The term “hedge fund” is one of the most widely misused terms in the investing industry. The first problem is that many “hedge funds” do not hedge – they don’t offset buying positions with short positions. So why are they called hedge funds? We have no idea.
The variety of hedge fund strategies is virtually endless. One hedge fund may just buy a few stocks in the public market. Another hedge fund might trade rapidly in derivative and option markets to capture large amounts of miniscule profits. The term “hedge fund” just refers to the structure of the investment but the success for investors is ultimately determined by the strategy being employed and the people managing the money.
There are hundreds of different hedge fund strategies. Each one works differently and derives value differently.
Main takeaway: Hedge funds are investment structures. There are thousands of hedge funds in the world and hundreds of different hedge fund strategies. Each strategy is different.
An Accredited Investor is an individual with financial assets exceeding a $1 million, personal annual income of more than $200,000, or a joint annual income of $300,000 or more. A Permitted Client, however, is an individual who owns financial assets having an aggregate realizable value in excess of $5 million.
In practice, the difference between an Accredited Investor and a Permitted Client is most relevant to the financial professionals that service them. Being that regulators deem Permitted Clients as more sophisticated, there is a lesser compliance burden for those that only serve Permitted Clients.
Main takeaway: Accredited and Permitted investors are able to invest in Exempt Market Securities. In and of themselves, Exempt Market Securities are not better or worse. Properly navigating this space, however, can be very beneficial to investors.
Alternative investments are very simple: anything except stocks, bonds, and cash. Alternative asset classes are the tools of the diversified investor, and include things like:
- Real Estate
- Private Equity
- Various absolute return and hedged strategies
Alternative asset classes should, at least in theory, provide returns that are not as correlated with public markets (e.g. stocks). Creating a portfolio of assets where some “zig” when others “zag” is important for reducing risk and uncertainty of returns over time.
Main takeaway: Alternative investments, when properly chosen, are critical for strengthening and protecting a portfolio because they behave differently than the traditional asset classes of stocks, bonds, and cash.
Protecting oneself from inflation is one of the most important goals of affluent, “stay rich” investors. As is commonly known, each year – in inflationary economies, like ours – inflation erodes the purchasing power of assets and makes each dollar worth less than the year before.
The best way to protect oneself from inflation is to invest in assets that offer protection. Since inflation is the rising of prices, investments that offer inflation protection typically have the ability to raise net income in lock-step with overall prices in the economy. Real Estate, for example, has this attribute as rents can generally be increased in line with a rise in price raises founder in the broader economy. Many companies that sell goods and services also have this admirable quality. Though, some of the most inflation-protected assets are the indispensable staples of any economy and/or society, such as farmland, oil or natural gas, and other commodities or hard assets.
Conversely, one investment to avoid in inflationary environments is bonds. Bonds pay investors a predetermined and fixed amount of dollars over time. So if inflation is higher than initially expected then investors will get less money than they bargained for. In public markets, this typically results in the value and price of bonds falling. An exception to this phenomenon is floating-rate bonds, which adjust interest payments upwards in response to a rise in inflation and interest rates.
Main takeaway: Over time, inflation is the silent killer of fortunes. Certain asset types, such as hard assets, for example, can protect investors from the steady attrition of inflation. Inflation is most detrimental to fixed-pay bond investors.
Diversification is not a simple formula and means more than merely holding a large number of investments in a portfolio. Proper diversification involves investing across many different asset classes that derive value from unique sources. (If you have two assets that are moving in completely opposite directions, the seemingly nonexistent relationship suggests they are driven by two different sources).
Every asset class has its ups and downs, and periods when risk is prevalent. An investor might be tempted to keep things simple and focus on one asset class without realizing they are over-exposed to the specific risks of that space. When there are wild swings in any one asset class, diversification can help to avoid agonizing or unbearable losses.
When it comes to geographic diversification, many investors are held back by “home bias” (i.e. a tendency to invest a disproportionate amount in domestic assets or equities). Canadians invest well over 90% in Canadian markets, even though Canada represents only a small part of the global economy. Investors must be wary that countries, like asset classes, have their ups and downs.
Main takeaway: Diversification is investing across different asset classes and geographies, and if done intelligently, can reduce the overall volatility of portfolios.