Investing Fundamentals

now browsing by category

 

Do Investors Understand Risks and Rewards?

By Ted Schwartz

I am a long term believer that good investing is a balancing act of evaluating how much you expect to make from an investment and how much risk is involved in trying to make that return. I believe this is a dynamic and changing calculation. When investments are expensive, your risk will increase and your expected return will drop. Not a good idea!

So, I was shocked to see the money flows for 2012 in mutual funds. About a hundred billion dollars went out of Equity Funds and into Intermediate Term Bond Funds. The expected returns for these bond funds are near an all-time low at this point. Their coupons (the amount paid to you in interest) are often about the same as the expected rate of inflation. So, in real terms you get nothing from that component. The only way you could make any money on the valuation side would be for interest rates to decline even further. This is not impossible, but there is not much room for further rate decline. History says rates will rise, the only question is when. That means the potential returns on these investments are very, very small indeed.

The risks? Due to rates being so low, relatively small increases in rates would likely cause relatively large declines in bond prices. A one percent increase in interest rates (still leaving us well below normal) would likely cause a loss of 5% or more in bond values. A two percent change would likely elevate this to double digits.

Why take the risk of these losses to potentially have such a small return on your investment? That is the question for which I cannot find a good answer. Anyone?

A Fine Whine

investment_img2

By Ted Schwartz

This week I met with two very bright individuals who parroted the CEO cry that we “need certainty” before the economy will improve and companies will hire people. At the same time, I am reading Taleb’s, Antifragile. His whole point would be that things in life are not predictable and actual results often do not even approximate the outcomes we think are possible. Taleb would argue that certainty is a bad thing, making us more fragile to the problems that will inevitably crop up in the future.

For me, the whole notion of certainty being a necessity goes against the grain of everything I know. The rationale for why entrepreneurs can earn more than employees is that they are taking a risk. The reason equity investors make more than fixed income investors is referred to as the risk premium. You expect to earn more due to the increased risks you take. Now, the cry is that we have to be assured of future results and of what taxes we will owe on our profits. We now refer to things like “making the tax cuts permanent.” The chart below shows the changes in the maximum marginal rates since 1913. Does this look like we offered “certainty” and low taxes up until President Obama arrived on the scene?

Graph

Let’s not forget that we experienced a huge amount of growth during the period since 1913. During this time frame we also experienced almost 20 recessions. Yet, we did not have entrepreneurs constantly saying they would not hire or invest unless they were given certainty of results. It is the cry of the 21st century entitled, “the successful class must be assured results before taking any risks.” It really can’t work that way.