Which is right for you?
To get something out of the way first. This decision is a personal one. I don’t care which you pick and I’m not here to tell you that you’re doing it wrong. I’m just trying to explain how this works.
That being said, let’s get started! This entire subject can be explained with just one word.
RISK
How much of it are you willing to accept in pursuit of your goals?
Let’s imagine you have $100 to invest. You’ve always been fond of birds for some reason, and so you decide to buy a racing bird. The guy who raises these birds assures you they are treated well and they all love to race. He presents you with 3 options. Since each bird individually costs more than $100 he says you can buy partial shares of the bird as well.
Captain Marvel
Bird Value: $1,000
Ownership: You can buy 1/10 of this bird for $100
Current Cashflow: $$$
Wins many races. A $100 race prize awards you $10
Risk of losing value: Low
Price upside: Low
A full grown bird at her peak performance, Captain Marvel is as consistent as they come. She’s won many races in the past and most likely will continue to do so for a few more years. Because she is already at the peak of her sport, it is unlikely that someone will buy Captain Marvel from you at a value of more than $1,000 in the future.
Lightning
Bird Value: $600
Ownership: You can buy 1/6 of this bird for $100
Current Cashflow: $
Has won 1 race. A $100 race prize awards you $16.66
Risk of losing value: Moderate
Price upside: Moderate
Lightning’s a bird that’s on the rise, he just won his first race. With the right care and training, this bird could grow into a consistent winner. However, there are always some birds that win once or twice and never go onto repeat those great feats. Should Lightning continue to develop into a star you will be able to sell him at a price of $1,000 in the future.
Rocket Jr.
Bird Value: $200
Ownership: You can buy 1/2 of this bird for $100
Current Cashflow: None
Has never won a race. A $100 race prize would award you $50
Risk of losing value: High
Investment upside: High
Rocket Jr. is a newly born baby bird. He’s the son of the great Rocket Sr., one of the greatest racers of all time. Rocket has the pedigree to turn into a future great. However, this baby bird has never won a race. Furthermore, Rocket Sr. had 2 other previous children. One turned out to do reasonably well in races, the other accomplished nothing in the speed sport. Should Rocket Jr. continue to develop into a great you will be able to sell him for $1,000.
So which bird do you choose? There is no wrong answer to this question! It is important to note though that nothing in this situation is guaranteed. You are predicting how good each bird will be in the future. To put it another way, you are projecting the future cashflows associated with your investment. Another thing to note is that the more tantalizing the future upside is for each bird, the more risk there is associated with each. There’s a risk/reward trade off with each investment. The more proven a winner the bird is, the more expensive the investment.
Real World Implications
Remember this always. Returns come with risk. There are no free lunches!
Anyone promising high upside investments with low risk, or even worse promising you guaranteed returns, either:
(a) Doesn’t themselves understand the risk associated with an investment
(b) Is lying
Using the 40 year period from 1973–2013, here’s what the data show are average returns for different traditional investments. Returns are listed in the first row and their largest decreases (drawdown) in the fourth row.
Finance has a way of using acronyms to make things more complicated. For convenience’s sake I added notes to translate things into plain English.
From the historical data we can see that larger returns come with larger drawdowns. US Large Stocks went up an average of 10.21% a year, but had a max drawdown of -50.95%. The US 10 Year Treasury Bond had a lower average return of 7.74% but also a lower max drawdown of -15.79%.
Volatility (the second row on the chart) tells a similar story. To put simply, volatility is a measure of how smooth of a ride it was to hold the investment. Lower volatility means there were less bumps along the way (and less risk).
The Sharpe ratio (third row) measures the return in relation to volatility. Basically, if you’re going to put up with higher volatility, you’d want to get higher returns for your troubles. A higher number Sharpe ratio is better.
I’m including the formulas for these in case you’re curious, but feel free to skip over them.
To apply this to today’s (March 2021) world, I’m going to combine some of the similar investment types together and I’m knocking bonds down the return ladder. Interest rates are at all time lows and the Fed may be compelled to raise them to fight inflation. I’m also going to add in crypto currencies and a couple well known “investments” for frame of reference on each sides of the next graph (savings account and the lottery).
This graph is not to scale, the lottery is way riskier than any investment. And since we’re now talking about today’s environment instead of prior history, you can quibble with me about the placement of a few items, but regardless of all that we can still make some observations.
The risk of the items on the left most side of this chart are low to non-existent, there’s very little chance you can lose your money but the returns are similarly tiny. You are not going to make any significant amount of money investing this way.
The returns on the right side of this chart can be extraordinary. Winning the lottery can ensure you never work again. Hitting on an option can net you 100%+ on an investment. However, the downside potential is also enormous. You can lose 100% of your investment if things do not work in your favor.
The following chart shows the math of gains and losses. For example, if you lose 50% in an investment, you’ll need to then make 100% to recover from it.
Notice that the lower your investment drops, it becomes more difficult for you to recover by orders of magnitude. For this reason avoiding large drawdowns is critical.
This brings us back to the original question. Get Rich Quick or Build Wealth, which is right for you?
To Get Rich Quick is possible but is not for the faint of heart. To realize these returns you must be comfortable accepting large amounts of risk and understand that even a single mistake can blow up your account balance. This route is achievable to those that do their own primary research and aren’t afraid to go against the crowd. (If you’re waiting for consensus, you’ll be too late.)
Those chasing the Get Rich Quick path should remember that higher returns always come with higher risk. You’ll hear your friends and family tell you exactly the opposite, but they’re almost certainly wrong without realizing it.
On the other side, Building Wealth over time is the less exciting but also more consistent way to invest. The key principle in building wealth over time is to let the power of long term compounding work it’s magic. There’s countless resources online about the mechanics and if you work with a financial advisor they’ll be steering you in this direction.
Or maybe you choose some combination. Choosing to build wealth over time when it comes to your 401(k) retirement plan and also have “side money” you invest in growth stocks or crypto in the hopes of finding some high upside winners.
No matter what you decide to do, know this. On a long enough time frame it’s really hard to mess things up. Remember that chart from earlier? Every single investment averaged positive annual returns over this 40 year time frame. Investing in anything was a win!
As long as you don’t do some disastrous damage to your portfolio, the odds are you’ll be just fine.
To be continued in… Part 2: How Not to Get Blown Up
