Some beginning thoughts on investing...

I think I’ve been beating up on debt long enough in my posts. I hope everyone reading realizes how bad of a situation we are in as a country. I hope it’s also caused you to question your own life and how you spend money and consume.

I’m going to start to transition into some information on investing. Being in business school during this economic downturn has been interesting, to say the least, and has been like a having prime seats at a movie, sporting event, or play. More like a play probably (ha!). I hope my observations are helpful as I begin to unfold some thoughts on investing and the financial aspects of our economy.

So…

Up until this economic downturn, why do people invest in the stock market? Historically, the main reason is that one could earn more in stocks than they could with holding cash or investing in bonds. The “risk premium” is the amount that one is supposed to earn in interest by taking the additional risk of owning a certain investment. If one doesn’t get paid a premium for taking the risk, they should look elsewhere to put money.

Now, over the last 120 years investors were paid approximately 2.0-2.5% more each year (on average) to invest in stocks than in bonds. Not bad, but problems exist. Depending on what investment a person is in, risk premiums can be higher than 2.0-2.5% or well below it (especially in economic downturns). Also not in this factor is something called "selection bias", meaning that funds or investments that ultimately failed over the selected time period weren't included in the calculations. This starts to get real ugly, though, when we have to face up to the fact that we have no idea when economic downturns will occur – or how long they will last.

So what does that mean? Earning a 2.0-2.5% risk premium is based on picking the right investment and also on timing. Well, that’s not very comfortable to me because it’s not something that can be controlled nor can it be predicted…more like random luck than investing. Heck, we might as well take cash to a casino instead and play, right?

Now, I’m not saying we should just give up and not do anything, nor am I saying we should sell all our investments and stop investing, or even take it to the casino. What I’m trying to get at though, is that we grossly underestimate risk.

We’ve been sold a bill of goods that says, “put your money in the stock market and you’ll make a fortune.” While that might have been more true during the developing dot com bubble (where even a monkey picking stocks off a page could have made money), it is not the case today. The markets are extremely volatile and we don’t understand risk. Putting money in equities (stock related investments) exposes you to the possibility that you could lose it all, some, or none. How many brokers tell you that at the outset of investing your money, hmmm?

Here’s a statement worth time to ponder: “Past performance is not an indication of future performance.” Meaning, just because an investment has had a decade of positive returns, doesn’t mean it will have another decade of such returns. Anyone heard of a little oil company by the name of British Petroleum (BP) that had a little problem in the Gulf of Mexico? Yeah, they had a stock that gained in value for years. Since the spill, their stock price has been pummeled. Think anyone saw that coming?

Gone are the days of “easy” investing…we all need to get comfortable with that fact.

R I S K. It has to be considered. It has to be understood. It’s more of a factor than we think.