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We recommend that investors follow an “evidence-based approach” with their investments. What does the evidence tell us? Investors should maintain globally diversified portfolios, keep costs low and select a mix of risky and safe investments that is suitable for their risk tolerance and financial goals.
Once a sensible portfolio is in place, holding on through the roller coaster ride of the market’s ups and downs is key to having a positive long-term investment experience. One of the biggest reasons investors underperform market benchmarks or even the funds in which they invest is their inability to control the emotional urges which can easily lead to bad investment decisions which knock them off course.
Too good to be true
One temptation to which we often see investors succumbing is the “too good to be true” investment product pitch. For example, many investments are sold as “equity-like returns with bond-like safety.” Upon closer examination a better explanation for such products is often “equity-like or higher risk with very uncertain returns.”
There are four key criteria that you can use to assess every investment opportunity that comes across your path:
- Expected Return
- Costs and Fees
- Risks
- Liquidity (how quickly you can get your money back when you want it)
The only reason we invest is to earn a rate of return. The rate of return compensates us for letting someone else have use of our capital rather than just leaving it in a high-interest savings account in the bank. What type of return is reasonable? Well, you shouldn’t be surprised to hear that the answer is “it depends!” And what it depends on is the other three criteria: the more risk, the higher the costs and fees and the more locked-up your money is, the higher rate of return you should expect.
To put returns in context, the long-term average total return on the US stock market (S&P500) since 1926 is about 10% per year. Returns for the Canadian stock market are a fraction lower since the mid-1950s. But let’s say going forward (just for example, no predictions here!) we expect stock returns to be somewhere around 6%-8%. You can invest in the stock market at a very low cost using index tracking mutual funds or exchange traded funds (ETFs) and get your money back if you need to within a couple of days usually: in other words low cost and very liquid.
Now of course stock markets are risky: while the long-term US average is 10%, there have been only two years between 1926 and 2017 where it’s been between 8% and 12% and you get some very big drops occasionally (think 1987, 2000 or 2008/9). So if you’re presented with an investment opportunity that offers 8-10% returns over a short period of time with a high degree of certainty you should be very skeptical.
Perhaps there are risks that haven’t been adequately disclosed. Does the investment rely on the return of a very specific and undiversified asset class like a single commercial property development? Is it a private investment offering where there is no secondary market where you can sell if you need to? Does part of your investment go to commissions to compensate the salespeople that brought you the investment opportunity? How much? Most of these details can be revealed by close examination of an offering document or prospectus. Unfortunately most people don’t bother to get into the fine print and sales pitches are designed to highlight the positive attributes and de-emphasize things like risk and liquidity or at most limit explanation to standardized disclaimers about the riskiness of investing.
Reading the fine print is important but sometimes not enough
While you can usually get a sense for expected returns and costs with a thorough reading of the fine print, it can still be very difficult to quantify certain risks. For example, if a fixed-income investment is offering higher returns because you’re lending money to projects with a higher risk of default, what does that actually mean? How much more return should you expect for that risk? If your money is locked up for five years, how much more return should you expect for that lack of liquidity? If your money isn’t locked up per se but the underlying assets are difficult to liquidate, what happens if many investors want their money back at the same time?
It is very difficult to evaluate and quantify the impact of different types of risk and liquidity issues. In our experience, many people selling investment products with these types of risk and liquidity issues don’t themselves understand the issues and therefore tend to put less emphasis on those issues during the selling process.
Missing the opportunity of a lifetime or dodging a bullet?
The bottom line is that you can construct an excellent and suitable portfolio using low-cost, diversified and liquid investment products that are well known with clear track records. If someone is suggesting you deviate from such an approach by purchasing an investment product that seems too good to be true, it probably isn’t good at all and the proof you need is likely to be found by closely examining expected returns, risks, costs and liquidity. If after reading the fine print, things still aren’t clear, walk away and forget about it: it’s unlikely you’ve missed the opportunity of a lifetime and more likely you’ve dodged a bullet!
Graham Bodel is the founder and director of a fee-only financial planning and portfolio management firm based in Vancouver, BC., Chalten Fee-Only Advisors Ltd. This blog is republished with permission: the original ran on July 24, 2018.
