Money 103: "The Perfect Investment"
Submitted by SharpMan Editorial Team on Saturday 16th October 2010- What is risk-adjusted return?
- How to make a safe investment with a return of 18-21 percent.
- How to quadruple your returns with little or no risk.
If you missed Money 101 and Money 102, check them out for an explanation of time horizons, risk tolerance, and asset allocation. Once you have these concepts nailed down, you’re almost ready to start choosing individual investments. But before you hit the "buy" button at the online home of your favorite brokerage house or mutual fund, it’s extremely important that you understand the concept of risk-adjusted return. This will ensure that you compare apples with apples when evaluating the various investment options available to you.
What is risk-adjusted return?
Risk-adjusted return is a concept that accounts for the risk of losing money when investing in items like individual stocks, stock mutual funds, or "junk" bonds. Even extremely safe investments, like bank savings accounts, pay some return. According to the theory of risk-adjusted return, a stock, which unlike a federally insured bank account has the potential to lose some or all of its value, should pay you a much higher return than one where both your initial investment (a.k.a. "principal") and your income (a.k.a. "interest") is guaranteed.
Risk-adjusted return is a way to measure, or a least think about, how much "extra" return you’re getting (or hope that you’ll get) for taking on some risk. Any investment with significant risk should return a lot more than what you can get in a safe investment backed by the full faith and credit of the government (which, unlike us, can always increase its income by raising taxes).
As a Sharp investor, you will always want to think about risk-adjusted return when evaluating your options, or last year’s portfolio performance, to ensure that you’re getting the most (potential) return for the least amount of risk. Just looking at returns or potential gain can be highly misleading.
For example, stock in a company that you think will increase in value by around 15 percent per year sounds pretty good — right? Well, maybe. It depends on the odds that the stock will go down (your guess is as good as anyone else’s) and the rate of return on safe investments like government bonds or even your bank savings account.
This is why you hear a lot about interest rates in the financial press. If a risk-free government bond is paying over 7 percent, then a stock (or other investment which can decrease in value) is a real dog unless it holds out the potential of much larger rewards (higher than 7 percent). In other words, why take risks if the potential payoff is no better than a safer investment?
So how do I make 18-21 percent return with no risk?
An investment that pays a guaranteed rate of 21 percent with no risk of a loss must be scam. Period.
That is, except in one case: the pay-off of credit card debt.
Once you understand the concept of risk-based return, it’s easy to see why paying off high-interest credit card debt is, for most people, the "perfect investment." Carrying a balance on your credit card is really a type of "inverse investment" — you are guaranteed to "lose" the amount paid in interest each month.
The money you save by avoiding these losses is just as green as the money you (might) make on a hot stock. Moreover, the "gain" from paying off your balance is risk-free since the credit card company is going to charge you the going interest rate each and every month you carry a balance. Hence, the guaranteed 21 percent (or greater) return is no scam but a solid piece of financial advice.
How do I quadruple my return with no risk using risk-adjusted return principles?
As you may recall from Money 102, each of us needs to have an emergency cash fund. Even a risk-tolerant investor with a long time horizon will want to keep 5-10 percent of his assets in cash. (You never know when you might get sick with something your health plan doesn’t cover, or your company gets downsized.) This emergency cash would normally go into some sort of bank product or a money market mutual fund.
But just because this is your most conservative investment doesn’t mean that you shouldn’t care about return! To the contrary, you want the highest possible return in a liquid investment that has the same, or less, risk as other options. Using risk-adjusted return principles, it is easy to really boost the return on your cash fund.
For example, an interest-bearing checking account pays around 1.25 percent, while a bank "savings" account pays a bit more. Depending on your bank, a "money market" bank account should pay in the range 4-6 percent (and often more if you’ve got more money in the account). At the mutual fund houses, Vanguard, a "no-load" fund leader known for keeping fund expenses low, was recently paying 6.38 percent on a money market account requiring a $3,000 opening balance.
SharpMan Tip: Note that a money market account, unlike a bank checking account, is not federally insured, so in theory it carries a bit more risk, even though a U. S. money market has never lost an investor’s principal.
The net result of moving your emergency fund from your regular checking account to a primo money market fund is a five-fold increase in your return — with a minimal increase in risk. Pretty Sharp. Too rich for your blood? If you want to be totally safe, simply go with a federally-insured bank product and "merely" triple your return.
Now that’s risk-adjusted investment principles at work!
This article last updated on Saturday 16th October 2010