One pillar of a great investment philosophy is believing that no one is spraying a confetti cannon full of cash out into the audience.
The stock and bond markets do not give out free money, and they don't exist to accommodate our preferences.
Investment companies package up products that invest in these brutishly competitive markets, pay their marketing teams to tie pretty bows on them, and create sales campaigns to sell to the masses.
This post provides brief perspective on considering investment products.
If we drew the line above, that represents being fairly rewarded for the risks we've taken, we'd reflect that the products from these investment companies are constantly marketed to convince us, the consumers, that it's easy to plot above the line. To convince us that if we buy their stuff, there is somehow additional, outsized reward available to us.
Hire us! Our product shifts you vertically upward.
But it doesn't work that way. There are immense forces that weigh down on any investment opportunity that might creep above the line.
People love to say that risk and reward are related, but it's surely an imperfect phrase. Consider chain-smoking cigarettes, reckless driving, or lying to a best friend.
It's really only prudent risks that are rewarded.
And there are two obvious times when risks should be taken:
The probabilistic reward is the same or higher than the probabilistic risk (e.g. exercise, or trying kidney beans for the first time)
The outcome is essentially required, so riskiness is irrelevant (e.g. being coerced, or undergoing a kidney transplant)
When it comes to investing, we typically focus on the first risk...though let's be honest – this is Wall Street, so you can always find a salesperson willing to sell you a solution to manage the second risk (and who is trained to convince you that you have the problem it solves!).
When we consider investment products that are marketed to put us above-the-line, we do so because there appears to be an opportunity that we shouldn't pass up. This might be in mutual funds, hedge funds, real estate deals, investing in startups, etc...
It's any time we think we will get a higher return for the risks we are taking.
Let's level set: in a world of ruthless capitalists, just being fairly compensated for the risks we are taking is a fabulous outcome. We should be thrilled to just be on the line itself.
When investment companies make outlandish profits by selling products to us, that money isn't created from thin air. The abyss below-the-line grows larger as more of us, the consumers, unfortunately find ourselves there.
There are sobering truths about the relationship between investment products and investors.
Here are three things we should ask ourselves if something sounds so compelling that it's potentially above-the-line:
Is there information in the fee structure? Something that is above-the-line before fees, can easily be below-the-line after fees. If it's truly a remarkable opportunity, we should expect to be charged commensurate fees. If they're maximizing the value of their product, then the company will charge investors as much as possible, just up until the point before investors fire them.
Why are they sharing? They might need money for this supposedly amazing opportunity, but they don't need our money. Why didn't they raise debt, or take out a business loan? What risks exist that are worth laying off onto us, that they don't want to underwrite themselves?
How long could this last? If something truly is above-the-line, it's hard to imagine it will stay there for long. If someone shoots cash out of a confetti cannon, it gets picked up quickly...until it doesn't exist anymore at all.
There are strong forces weighing down on investment products. When confronted with an opportunity that appears to deliver outsized, risk-adjusted returns...it's best to remind ourselves that it more likely toes the line (at best), and we just haven't yet considered all the risks.
It's heavy above the line.