Investing - Part One
Finally, the most exciting part of personal finance: investing.
Whether it be stock trading or buying crypto, the word investing probably conjures up a certain image in your head. You can find countless "pundits" from CNBC to YouTube talking about all the potential profits of an endless array of investments.
While profits are nice, we at Guardian believe that it is far more important to avoid big losses. Very simple math explains why this is the case:
Suppose there are two investors, Bill and Nima
Bill invests $1,000 into volatile meme stock A and the price starts falling so he takes a 50% loss to get out; he then invests the remainder in stock B for a 100% profit
Nima invests the same $1,000 into safer blue chip stock C and suffers a 10% loss; he then invests the remainder in stock D for a 20% profit
Even though Nima’s investments were much less exciting (his 20% profit vs Bill’s 100% profit), his losses were also much less severe (his 10% loss vs Bill’s 50% loss). As a result, Nima walks away with a $80 profit while Bill leaves with zero profits (😢).
In fact, suppose Bill lost 75% on his first investment, he would have to make 400% on his second one to get back to no loss.
Remember this: big losses require even bigger profits to break even.
It doesn’t matter how much money you might make on the upside if there’s the probability of suffering a big permanent loss is too high. Or as Andrew Carnegie put it: “Watch the [losses], and the profits will take care of themselves.”
As such, our goal here is to lay out the common ways to identify bad investments so you can evaluate each investment opportunity and filter out the ones that should be avoided.
Criteria One: Reasonable Risk
First off, we will define risk as the probability of a permanent loss of your capital. While there are multiple finance and economic degrees between Nima and I, we disagree with the Modern Portfolio Theory’s (MPT) definition of risk as volatility, or how much the price of an investment fluctuates (also known as beta or standard deviations). Volatility is calculated as a price change divided by the original price (For future reference, division is often symbolized as "/").
This may sound like heresy to those of you who are knowledgeable about finance, so let us use an example to illustrate our point:
You purchase a farm today for $100,000 with the expectation that it will produce $10,000 per year in profits; your neighbor who owns an identical farm congratulates you warmly
At the end of year one, your neighbor sells his farm for $50,000; your farm has generated $10,000 as expected
At the end of year two, the farm next door is sold again for $25,000; your farm has generated another $10,000 in profits as expected
In this example, since an identical investment (your neighbor’s farm) has been sold at a 50% price decline two times in a role, according to MPT, your investment is ultra-high risk. After all, 50% movements year after year are some high volatility. However, knowing the farm is reliably producing the $10,000 annual profits, where is the risk? Your best course of action is to dismiss the stupidity next door and continue collecting your investment profits.
The point is that the quoted price, that number you see jumping up and down all the time, is a result of human decision-making, and humans often are not very rational. People often display herd mentality, buying because other people are buying, without much care for why they are buying. People are also greedy, willing to buy things with no value solely for the purpose of persuading a greater fool to take it off their hands at an even higher price. These behaviors are both risky and socially harmful.
At Guardian, we believe every investment should have a strong underlying value. Imagine there's a moderately profitable candy company that owns $10 worth of land, $5 worth of equipment, and $5 in cash ($20 total). However, the broader market is feeling bearish (speculating that the market will crash). As depressed investors rush to sell everything and anything, they push the company’s price to $15 on the stock market.
We believe this is a low-risk investment because there is at least $20 of intrinsic value that we bought for cheap. It’s like buying a $20 bill for $15, a pretty good bet in our eyes (this is called a value investment, discussed in more details later).
Now suppose that people discovered their candies contain a type of carcinogen. The company becomes unprofitable as it fights lawsuits and pays for the harm it has caused. However, the broader market has become bullish, and euphoric investors rush to buy whatever they could get their hands on to ride the bull market. The company now trades at $30 on the stock market.
We believe this is a high-risk investment because despite the rising stock price, the business itself is crumbling, and the company is turning into a house of cards that will ultimately tumble with investors holding the bag.
Criteria Two: Payback Period
Let’s say a financial advisor presents two investments to you: investment A that will return $10,000 per $100,000 invested or investment B that will return $20,000 per $100,000 invested? Which one will you choose?
What if I now told you it takes investment A one year to deliver the return and it takes investment B ten years? Which one would you choose now?
When evaluating an investment it is very important to not only look at the potential return but also to consider how long it will take for those returns to be generated. In the above example, investment A represents a 10% annual ROI while investment B only represents a 1.84% annual ROI. $100,000 invested in A turns into $259,374 after 10 years, while the same $100,000 invested in B only becomes $120,000.
Oftentimes, salespeople selling investment products with low ROI will try to direct their customer’s attention to the money they can expect to receive at the end to make the product look more appealing. “This annuity will give you $432,194 after 30 years for every $100,000 you invest today” sounds a lot better than “this annuity only has an ROI of 5%”.
Up Next…
Investing is a complicated topic that we just can’t squeeze into one article, so follow us over to part 2 as we talk about fees and liquidity, as well as the most common ways to invest your money…
