Higher yield without more risk
In my previous article I alluded to how I solved the problem of personal investing. How I broke through the barriers of fear and knowledge to obtain the sense of certainty that I was making a good choice. Many of the challenges that I dealt with included: overcoming the fear of crashes, evaluating risk and how to invest my pension. Another problem I had was getting a decent rate from the banks. I wanted to find a higher yield without more risk.
…banks are paranoid about managing risk…
Well thanks to my time working at German banks I learned a lot about managing risk. In spite of their reputation, banks are paranoid about managing risk. They have entire departments dedicated to risk. And I worked in a risk department for many years. So, I have a clear understanding of risk and how to minimize it.
Why do banks fail?
You might ask, if the banks are so focused on risk, why did so many of them fail in the previous crisis? This is because of market distortions created by the Federal Reserve Bank (the Fed). You have no doubt heard of the fact that the Fed is constantly raising and lowering interest rates. Well when the Fed lowers interest rates this makes borrowing cheaper.
When borrowing is cheaper people borrow more money – usually for mortgages. However, lowering interest rates eventually causes inflation. When inflation gets too high this can cause a loss of confidence in the dollar.
So eventually the Fed must raise rates again. However, people who have mortgages can no longer afford the payments. So, they default on the mortgage and don’t pay back the bank. On top of this, lots of companies can now no longer afford to repay their loans and they go bust. The banks don’t get repaid and then they go bust because they cannot repay their loans either.
Unfortunately, not many people in the banks understand this process. But they get bailed out by the Fed so they’re OK. Not you and I however. I worked for years to get the bail out money back for taxpayers and was rewarded with being laid off. But this is a topic for another day. Let’s focus on you discovering how to invest.
What is risk?
We say “manage” or “minimize” risk because you cannot eliminate risk entirely. In finance we speak of unsystematic risk and systematic risk. Unsystematic risk is the risk of the particular company stock or industry that you are invested in. Stated differently, it’s the risk that that company’s stock price will fall. Or even that the company will go bust. If you invest in one single stock there is a definite risk that you will lose all of your investment.
Protect your self from risk
By diversifying into other companies or industries you can protect yourself from this risk. This is because when the value of one company goes down, the value of others may go up. To get the full benefits of diversification you might want to invest in a broad market portfolio (such as a fund that tracks the S&P 500). Additionally, you might invest globally where these other markets are not fully correlated with the American stock market. In this case, if one company goes bust it probably won’t impact your overall investment.
Systematic risk is the risk that the entire market may go down. This can be caused by global macroeconomic events or changes in policies by the government or central bank. It can affect all companies similarly. Obviously, this is a huge concern to investors like us. A big bank can get a bail-out from the government. You and I can’t. And we don’t want to lose our retirement. What can I invest in that isn’t going to disappear with the next economic collapse?
Financial crises aren’t so bad…
Well first of all, it’s important to remember that even when the worst happens, it’s not usually that bad. The S&P 500 (which is one of many measures of the value of the stock market) half its value in the financial crisis of 2008 but still returned a positive return for the 10 years from January 2007. The average return was 5% which is better than the negative you are currently getting from the banks.
Secondly, different asset classes react differently to big market events. Bonds tend to improve in value when stocks go down. This is because bonds tend to be poorly correlated with stocks. So, you can see how having both in your portfolio can protect your wealth from the risk of losses.
However, stocks and bonds have become more correlated recently. So, what do you invest in now? How can you reduce the risk of losses? Well what worked well for me was gold. It is uncorrelated with both stocks and bonds. I spoke about this in my previous article so check it out.
Fundamentally, though, you should keep in mind that if you are widely diversified across different asset classes, markets and countries, you won’t lose all your money. The people who tend to lose their shirts in investing are the ones that go all in, in high risk investments, like crazy real estate deals in Dubai…
Diversification and risk
When I worked for the German banks I specialized in real estate debt investments for many years. Here I looked at various risks. The most important risk to a bank is credit risk. This is the risk that the borrower will not repay the loan. But since I was analyzing real estate there were other risks. I had to be concerned that the value of the building would go down. This was valuation risk. Or the tenant in a building would go bust. Interestingly enough we used the principle of diversification here. If the building had a lot of tenants across different industries we were not concerned about one tenant going bust. This was not an unusual event.
On the other hand, sometimes, we only had one tenant. However, if the tenant was high quality (like Microsoft for example) we were not concerned. And you can apply this thinking to stocks. If you’re going to invest in one company’s stock you should pick a high-quality company. There is a simplification though. You always want to sufficient analyze a company to determine that it really is high quality.
How to invest for your personal portfolio
For many people this is going to take too much work. Using the principle of diversification can help here. I’ll talk more about this topic in later articles. In my case however, since we were only making a handful of investments, deep analysis was necessary. But this was what I was being paid to do. However, while I spent my days analyzing investments I certainly didn’t want to spend my evenings and off days with another full-time job monitoring my personal investments. Plus, as I said, my specialty was real estate debt. Did I really have time to learn about investing in the stock markets?
It turns out that I did. And I spent all of this time (evenings and days off, vacation time, etc.) studying the CFA curriculum for many years. Eventually I obtained “the highest distinction in the investment management profession — the Chartered Financial Analyst® (CFA) designation”.
The breakthrough!
Through a combination of this program and the many years spent working in investment I finally made a breakthrough. I discovered the secret to successful investment. For you, to be a successful investor you have to follow this process:
- Determine your goals:
- Saving for retirement
- If you have a family ensure that they have a secure financial future
- Leaving something for charity
- Prioritize these goals:
- Is it important to you that you can maintain your lifestyle in retirement?
- Do you want to maintain your lifestyle while your children and your wife can live comfortably?
- Be more conservative with the most important goals
- Determine how much risk you can tolerate:
- If you used to be a day trader you are probably familiar with risk taking activities
- If you only have a small amount of savings then you probably cannot afford to take major risks
- Based on the size of your goal and your risk tolerance you can determine a realistic return
- Allocate your savings to an appropriate, diversified portfolio that will achieve this rate of return
- Review your goals, risk tolerance and investments annually.
Make sure you have a plan!
What I find happens with most people is that they do this process backwards. They move from various investments with no sense of a unified plan. They know that they want to retire comfortably and take care of their families. However, there is no connection between their goals and their activities.
Fast money leaves fast
For example, one of my clients told me that he tried foreign exchange trading. The account was on a bit of a losing streak so he decided to do close the account. So, he moved it into buying some jewelry and made my money back plus 15%. He was basically moving money around to make money. He was making some money and then losing some money. “Fast money leaves fast” as he told me.
Another client told me he dabbles and looks for long-term investments. However, it seems the stocks he picks go south just after he decides to buy it. The trouble that both of these guys had was that without a plan or a full understanding of their own personal situation they could not pick investments that were appropriate for them. They could not pick investments that would help them achieve their goals.
Let your investments pick themselves
With such a plan your essentially investments pick themselves. For example, say that you know that to retire comfortably you need to invest $1000 a month at 8% for 20 years. Additionally, it is vital that you achieve this goal. In this case, you know that you need to invest conservatively. But you also know that investing this way, you have a good probability of meeting your goal. Your plan will tell you where, how much and what return.
What about a lower priority goal like investing for the kids? We say lower priority because you do need to take care of yourself first. Well if you fall short of this goal your kids will still love you. Therefore, when you invest for the kids you can afford to be more aggressive. Maybe a higher allocation to stocks than in the first portfolio.
Theory and practice
So, between my time at the banks and my time studying the CFA curriculum I learned both theory and practice. At the banks I went deep into understanding how individual investments worked. I learned about how to create investments so that we could reduce the risks of losses. More importantly, l discovered what happened when risk wasn’t managed properly. At the banks I was dealing with individual investments.
Be certain that you’ve made a good choice!
From the CFA curriculum I discovered how to invest for the long-term. How to build wealth for individuals. The individual that I was most concerned with at the time was me. So, for my personal portfolio I applied the principles I have described to you in this article. I figured out my goals. Then, I prioritized them. I figured how much risk I could tolerate. I determined what return I needed. Next I allocated my investments between stocks, bonds and commodities. Now I can be as certain as possible I’ve made a good choice.
Just one more thing about choosing investments. One principle I never forgot from my studies. Any investment should “have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action.”
Stay awake from slick brochures…
A slick brochure advertising a real estate opportunity in Dubai does not have a reasonable and adequate basis for investment. Many people have been suckered by these types of investments and lost serious money. Make sure any investment you make is with a reputable company. These organizations will have exhaustive amounts of material to give you.
Now you may be thinking that you don’t want to spend your evenings and days off studying investment. Probably you don’t have a job in investment. You won’t need it. You won’t need to learn how to analyze individual investments. Neither do you need to study every aspect of investment theory. You only need to know how to invest for your specific goals.
This knowledge can be achieved relatively quickly. I am here to help you with that. If you want to learn how to get more deeply involved in investment that it is up to you. I can help you with that too. Write your questions in the comments section and I’ll answer them for you. In the meantime, look out for my next article where I talk about how exactly I applied what I had discovered.
Patience is definitely the name of the game. My husband and I are an interesting team in this regard. He does the “backwards math” for goal planning, and I help him be patient when the stock market seems volatile. 🙂
That’s the key! Jumping out of the stock market when its more volatile and going back in when it settles can cost you money rather than save it. And depending on your appetite for volatility there are other investments which have much less volatility than stocks.