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Higher risk, more reward.


Would you rather have investment one that is “safe”, but pays a low reward or would you rather have investment two that is more risky but has a higher payout.

Well obviously, I’d rather have option _____…

Well of course you would, that’s the only answer that possibly makes sense.

I hear the above thrown around all over the place in the investment world. The problem is, this statement is worthless without any context. What we don’t learn in Finance 101 (or any other finance class according to my little brother who recently completed a degree in the subject) is that the things that make an investment risky or safe are often subjective.

Any investment is safe until it isn’t.

When we make an investment decision, it isn’t important to simply assume that “higher risk means more reward” or even that “lower risk means less reward”. Worse than that, I hear traders talking all the time about “well this strategy is riskier, but it pays off better”

Really? In the long run does it actually pay off better? Well fantastic, sign me up! Wait a minute, it pays out great, except every now and then when we get a 45% drawdown. Well that isn’t so cool. How long does it take to work out of that drawdown? How well has this worked over the past 6 months, year, etc… Let’s take our risky example one step farther. Let’s say it paid out 300% in 2010. Well heck, that’s great. Sign me up. But then we have our 45% drawdown in Q1, 2011.

So, we gave this “investment” $10,000 on Jan 1 2011 By April 1, we only have $5,000 left. Wow, maybe that’s what we mean by risky? Should I pull my money out and stick it under my mattress? In the bank? In some “safe stock”?

Assuming that something in the market changes and we are actually able to replicate 2010’s success over the next year (in my experience, this isn’t very likely but let’s go with it). 300% return on 5K is 20K. Oh ok, well, we doubled our money in a 1.25 years. That isn’t too bad is it. But remember we had to lose almost half of it first. Guess what happens next, we have our 45% drawdown again. (I guess these things pop up every 15 months or so.) Now we’re sitting right at $11,000. So in 18 months we’ve managed to net a 10% return. That’s right around 6% a year. (Assuming we don’t get two of our drawdown periods in a row).

Well heck, for that return, I think I’ll stick my money in a bond, now that’s a safe investment.

But what kind of bond am I going to buy? I hear Greece is lovely this time of year.

My point is, just because something is risky, that doesn’t mean it will pay off well in the long run. Also, just because something paid off incredibly well for a period of time, we can’t assume it will continue to do so, but nor can we assume necessarily that the investment is risky. Has gold been a risky investment since 2001? Not really. But how about silver? Well, depending on when you buy, ya.

I’m going to take my 11k, take 1 of it and buy some new tires for my car and invest the rest in a really safe investment. The banking industry has been around forever. That’s a safe investment.

Prior to 2009, the financial and banking industry was where it was at. And why not? This was a safe investment. The housing market was booming. Banks were thriving and new ones were starting up all over the place. Say, we don’t like stock in one singular bank. One bank can have issues can’t it? But, how about the granddaddy of all banks, the one that can’t fail, the one that buys stuff from all other banks out there and sits on assets for a long time.

How many times have we heard “but it’s ok, because I’m in this investment for the long run”. That makes sense right? We’re in an investment that turned bad, but that’s ok, because we’re in it for the long run. When exactly does the “long run” get here? Because eventually, I’m going to want to use my investment for income or retirement etc.

So, our novice Mr. Buffett here sticks his $10,000 into a bank stock.

What stock am I talking about? Well the ranking Democrat on the Financial Services Committee in 2003 said: “These two entities are not facing any kind of financial crisis” and ”the more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing”. So good old Barny is basically saying ‘people need to shut up and leave my pet companies alone… (they paid to get me elected after all…)’

Assuming Barny was just plain stupid and not actively malicious or anything, I’ll keep this to the numbers not the politics. In 2003 FNMA traded between $58 and $69. Not bad I suppose for an established company. In retrospect though, Feb 04 was a relative high at $80. Where do we trade now? $0.33 (yea that’s right 33 cents folks). How many times do you have to multiply .33 to get back to 80? 242 No, that isn’t 242% return either. (math doesn’t work like that) $0.33 $0.66 is 100%. etc.

Is my math right? Getting my $.033 back up to $80.00 is almost a 25,000% return. Wow, now that would be pretty cool. And all this trouble because I made a “safe” investment. Can I make money on this stock? Sure, I can buy it at $0.33 and sell it below $1.00. But I need a decent sized account if I want to pay for all the trading fees. Still that strategy has worked pretty well since 2008. But that isn’t an investment. See, making money and investing are two different things.

So how do we pick our investments? Well, I pick mine technically, and I don’t call them investments I call them trades because I believe trading is less risky than investing.

What about my real estate investment, surely they’re long term right? No they’re not. I bought apartments in 2006 with the intention of holding them for a long time. I sold them in 2010. How well do you think that turned out? Today I’m closing on a house that I will sell in 2-4 years. How well is that going to turn out?

As far as % return, it’ll turn out very nice. What am I doing? I’m trading, just on a longer term chart.

Stay tuned for a discussion about how Forex trading isn’t that risky. That should be interesting. Everyone knows trading is risky right? Of course it has risks. But like I said in the beginning of this, “risky” is subjective. If done correctly, trading has a lot fewer risks than investing.


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