Investments that make me go Hmmmm…
I consistently advocate for investing in a diversified set of low cost, index-based mutual funds or ETFs (Exchange Traded Funds) that matches the time horizon for when you will need the money and your risk tolerance. Academic research has shown that this is the most reliable way to achieve good risk-adjusted returns over time.
Questionable Investments have poor risk-adjusted returns
The key phrase is “risk-adjusted returns.” In investing, the greater the risk that you will lose money, the greater your expected return will be, usually. But more risk does not always equate to higher returns. There is one, primary, well-documented method for reducing risk while maintaining expected returns: diversification. You only want to add risk that will lead to greater returns.
- Individual Stocks or Bonds: There is an obvious lack of diversification here. One stock or bond is more volatile than a fund full of them, because an individual stock or bond carries the additional risk of that specific company failing. I wrote about this awhile ago in “Individual Stocks are Risky” https://krehbielfinancial.com/diversification-reduces-risk/ . That article cited a Morningstar report that showed that 34% of individual U.S. stocks went down in value in the past 5 years, but only 0.2% of U.S. stock funds went down in value.
- Too much stock in the company you work for: Hopefully, you think the company you work for has a promising future, which may make you want to own the company’s stock. But since your current income is tied to that company, tying more of your finances (i.e. some of your investments) to the same company greatly increases your risk, and therefore decreases your personal return vs. risk.
- Whole Life, Universal Life, Variable Universal Life (etc.) Insurance: These products are sold as investments plus life insurance. As with many compromises, these are sub-optimal; they are expensive as insurance, and relatively low return as investments.
- Long-term Bonds: Long-term (>10-year) bonds carry much greater risk from future inflation compared to <10-year bonds. In the current environment there is not much difference in the interest rate (return) you will receive on longer-term bonds, so the return vs. risk is less appealing for long-term bonds.
- Commodities: Commodities are very volatile, and therefore risky, and they have historically poor returns compared to both stocks and bonds. Low return and risky = stay away.
- Cryptocurrencies: My issue with cryptocurrencies is that there is no historical record, so the expected return vs. risk is essentially unknown. Add to that the ability of the U.S. government to shut down any cryptocurrency it chooses, and this looks like a very risky investment to me.
Whenever you are investing, you should consider the return you expect to get and the risk you are taking to get that expected return. Many available investments, like the ones listed above, carry more risk than better diversified, or lower cost, investments.