Know what you’re getting yourself into

Suppose I gave you 3 investment options:

  • Investment A charges 0.05% in fees per year
  • Investment B charges 0.20% in fees per year
  • Investment C charges 1.5% in fees per year

Which would you choose?  

A lot of investors, and their advisers, would blindly choose Investment A because they believe lowest fees always win. To which I would ask: lowest fees for what? The goal of investing is not to minimize fees, but to preserve and grow capital.

Suppose I gave you 3 new investment options:

  • Investment A has 0% standard deviation over 5 years
  • Investment B has 18%  standard deviation over 5 years
  • Investment C has 68%  standard deviation over 5 years

Now, which one would you choose?

Most finance professors, investors and their advisers would chose Investment A because they believe lowest volatility wins. Risk equals volatility, they’d say, so reduce risk by investing with lowest volatility. To which I would ask: is the goal of investing to avoid volatility, or generate returns?

Suppose I gave you 3 new investment options:

  • Investment A has returns of 5% a year for 5 years
  • Investment B has returns of -8%, +20%, -8%, +32%, and +20% over 5 years
  • Investment C has returns of -5% a year for 4 years, then jumps 146% in year 5

Now, which investment would you choose?

Most investors would choose A because B would be “too much of a roller coaster ride” and C would “go nowhere” for too long. To this situation, I’d ask: is the goal of investing the avoidance of “roller coasters” or “going nowhere,” or to generate returns?  

Suppose I gave you 3 final investment options:

  • Investment A generates a 5% annualized return over 5 years
  • Investment B generates a 10% annualized return over 5 years
  • Investment C generates a 15% annualized return over 5 years

Which would you choose this time?

Most investors and advisers would chose Investment C because it produces the best return.  On this one, I’d agree.

If you recognized that Investments A, B and C were consistent throughout my examples, then excellent observation on your part.  

Investment A is basically a saving account or Certificate of Deposit (not that you can find that kind of yield now). There is no daily market quote for the instrument so it appears not to fluctuate at all (which means the volatility appears to be zero), the fees are very low, the returns are steady, but the result is low compared to other alternatives.

Investment B is basically an index fund invested in the stock market. The fees are low, but not as low as at the bank, the returns are unpleasantly volatile–hence the roller coaster comment–but generate a very respectable return of 10% per year (assuming the market is at average value).

Investment C is basically a value-style investment. The fees are high, the standard deviation of returns is quite volatile, the investment goes nowhere for 4 years before taking off (meaning that it doesn’t track with the overall stock market–which vexes professors, investors and advisers to no end!), but the returns are truly outstanding.

My attempt here is not to say that investment C is the right choice for everyone–it most certainly is not–but to illustrate the choices investors are faced with and some of the inherent trade-0ff’s they must make.

If you believe that low fees are the most important criteria, then I’ll quote Oscar Wilde: “The cynic knows the price of everything and the value of nothing.” Price is what you pay, value is what you get. It’s a mistake to look at price and not what you get for that price.

If you can’t stand volatility of any kind, like watching your investment double one year and plunge 50% the next, then you should probably avoid the stock market. If 5% returns aren’t enough to allow you to reach your financials goals, you have a true dilemma on your hands. If 5% returns will get you where you want or need to go, then why bother with more volatile options?

If you invest in stocks, don’t expect 10% returns each and every year, but 10% returns over time assuming you invest when the market is at fair value. If you invest when the market is high, you won’t get 10% returns; if you invest when the market is low, you’ll do better than 10%.  In either case, don’t expect a smooth ride. There is no such thing as a free lunch, so don’t expect to invest in the stock market and get bond-like or savings-account-like returns.

If you want better returns than a saving account or the stock market offers, then don’t expect steady returns or returns that track the market. To do better than the market, you may have to be willing to “go nowhere” for quite some time.  Better returns will very likely be more volatile, look very different than the market, and test your patience. Conversely, an investment that is steady or mirrors the market is extremely unlikely to generate above average returns.

Successful investing is less about fees and volatility and more about knowing what you’re getting yourself into. If you buy C and expect A or B, you’ll be disappointed and bail out before good results accrue. If you buy A and expect B or C, you’ll be disappointed with low returns. If you buy B and expect A, you’ll be scared out by volatility. If you buy B and expect C, you’ll wonder why you’re not tracking to the market.

Most financial plans fall apart not because things go awry, but because people don’t know what they are getting themselves into and bail out at just the wrong time. Successful financial planning begins with a clear understanding of the options, the likely outcomes, and the probable path to the destination. People leave a restaurant when they expect steak and potatoes and get foie gras and escargot.  

My wife has a saying, “you knew it was a snake when you picked it up.” Know what kind of snake you’re picking up, and don’t judge it by nonessential characteristics.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Know what you’re getting yourself into