Risky business

Understanding when something is risky is just as important as figuring out how profitable it will be.  What would you do if you had to choose between A) climbing a rusty 8th floor balcony railing in your slippers to get a candid photo of your “chesty” next door neighbor or B) learning how to use the internet and just googling “chesty next door neighbor” (Don’t google it at work).  Unfortunately, assessing investment risks is never this simple.

Increases in return = increases in risk.  More often than not, the better the ROI the more risk is involved. For example, you can potentially make more money investing in sexy penny stocks than boring government bonds.  On the flip-side, penny stocks are more likely to declare bankruptcy, governments rarely go bankrupt (please ignore Argentina, Iceland, etc).  To simplify, equity (stocks) is associated with higher risk while fixed income (bonds) is considered to be a lower risk investment.

Should you go balls out, invest in tech stocks and become a millionaire in a few years? Or, should you diligently put money into safe bets, knowing that these will steadily fund your retirement?  It depends on your personality but it also greatly depends on your age.  Age determines risk tolerance.  All things being equal, the younger you are the more risk you can tolerate.  When you’re in your 20’s, it’s much easier to lose everything, move back into your parent’s basement and curse the stock market to hell.  At 65, rebuilding your entire net-worth while wearing soiled Depends® is an adventure none of us should embark on.

It’s important to keep risk assessment in mind when choosing various investments.  A useful guideline is to subtract your age from 100 to arrive at the equity portion of your portfolio.  As you get older and hair migrates from your head to the rest of your body, you should shift investments from equity to fixed income.  A 20 year-old should have an 80-20 mix of stocks to bonds, when they turn 45 they should aim for a 55-45 breakdown, by the time they are 100 the stock market should be the last thing on their mind.

***If you like bungee jumping, sky-diving or cliff jumping, feel free to change the above rule and subtract your age from 110.

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Critical thinking

Isn’t it strange that every car in a used car dealership looks like an amazing deal? Why is it each time you speak with a mortgage broker there is “no better time to buy”? How come after a year of going to your chiropractor, there is still a slight misalignment that requires 12 extra bi-weekly visits? I don’t know, seems legit to me (I’m seeing Dr. Silverstein tomorrow). Anyways, for no apparent reason today’s post will be about critical thinking.

Critical thinking (or the ability to separate fact from fiction) is a fundamental skill that extends to all aspects of life. If there is one thing the world is lacking, its people who use personal research to make up their minds about important issues. For example, I don’t need to watch a 12 minute video to realize that things are bad in Africa. I KNOW things are bad (that’s why I vacation elsewhere) but how is sending $30 to an unproven charity going to help?

Don’t make any financial decisions until you have considered all of the alternatives and consulted multiple professionals (or blogs). Don’t be shy about asking how much commission these “advisors” will earn from playing around with your money. Don’t sign anything without consulting a lawyer first. Above all seek transparency, accountability and a sexy smile.

Seek a fee-based financial advisor who will charge you an initial fee for setting up a portfolio, provide tax shelter advice and give you the option of coming back annually to rebalanced your portfolio. Run-of-the-mill advisors will try and push products that pay them the highest commission, your needs for steady returns will be a secondary concern. View advisors as booty calls; when you need some advice, call them up, do the deed and be out the door before they can say “mutual fund”. Don’t stick around to cuddle, it ain’t worth it.

Sizing up your investments

So lets recap: you’ve got a fresh budget, expenses are being tracked online, spending limits are set and there’s a few extra benjamins winking at you with each paycheck.  It’s about time to consider investing.  Don’t let the cheddar sit idly in the bank, put it to work.

A good starting point in choosing an investment avenue is to consider Return On Investment (ROI).  This is a handy yardstick that sums up how efficient (profitable) an investment will be.  The formula is straightforward: 

ROI = (money being made – money being spent) / total money invested

Multiply the ROI by 100 and you will get a percentage, obviously the higher the ROI the better the investment but there are some exceptions.  ROIs do not reflect how much risk is involved and they do not take into account how much work is required.  For example, investing $10,000 in a conservative diversified portfolio may only produce an ROI of 5%-10%.  That’s as vanilla as Martha Stewart baking an apple pie.  Buying a rental property, taking on a mortgage and finding a tenant could produce a much higher ROI.  In this case you get to live out your fantasy of being a superintendent!  Smuggling cocaine from Columbia and pushing it onto the mean streets of Toronto could net an insane ROI.  This last case takes into account your willingness to spend the twilight years of your life sharing a cell with “Big Tyrese”.

The goal is to find that sweet spot.  Consider how much effort you are willing to put in and how much risk you can tolerate.  There are more important things in life than making money efficiently.  Sometimes it’s better to pick the lesser ROI, especially if it means not having to spend your evenings making shivs from toothbrushes and soap.