Category Archives: Investing

The correct way to look at debt …

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BradOK asks:

What’s a better use of my money – pay down debt or invest it in the market?

To which JillyBean responded:

At what rate of interest is your debt? How much debt do you have? Do you have an emergency fund? If you invest your money, what is the purpose for the money — short term or long term? The markets are on a downward spiral and very volatile — it might be more prudent to answer the above questions to determine the answer for the actual question.

You could always compromise and do both! It never is bad to pay down debt.

But, I am always working from the assumption that you want to get rich /stay rich …

… if that’s also your mindset, you might have more clarity if you rephrased the original question as “what’s better, to INVEST in debt or INVEST in the market?”

Once it’s clear that you are making an INVESTMENT every time you pay off debt – even personal debt – or, decide not to, then you will realize that you simply need to consider relative returns.

Then it will suddenly become clear that INVESTING in debt returns you a guaranteed rate equivalent to the interest rate (plus ongoing fees, if any) being charged. On the other hand, investing elsewhere MIGHT return more, over the long-term.

So, your real question that you need to answer is: “What investment will give me a greater AFTER TAX return than my highest interest rate currently outstanding debt?”

If you can find one (and, you have the required skills/interest/knowledge/stamina) then invest in that, otherwise pay down some debt.

Naturally, start with the highest interest rate debts first and work your way down (remember the ‘debt avalanch’?)

We're split down the middle …

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… some agree that paying down your mortgage is the dumbest decision that you can make (not really the dumbest …. but certainly down there with the best – I mean, worst) and some simply don’t agree.

Right now, though, I want to pick up on one of Nick’s comments, since he has summed up the ‘pro-pay down argument’ really well:

I do a decent amount of investing myself, and while I don’t claim to be a master of the trade, I do well. That doesn’t change the fact that I don’t know how my investments will turn out. Everything could go horribly wrong, and I could end up taking quite a hit… or it could go really well and I could make a killing.

I don’t think anyone really knows for sure how well their investments will perform. I think anyone who does is either lying or fooling themselves. It is all about managing risk.

Putting a sizable portion of your cash as a down payment, and making prepayments to pay off your mortgage, is very good way to minimize risk. You end up with lower monthly obligations, less debt, more equity… Of course, this means less free money to invest and less money making potential..

Once again though, risk management philosophy comes into play. Is your primary residence something you want to take the risk with? In today’s market, putting less down, and making lower payments would turn out to be a very costly mistake if your investments don’t net the return you wanted (you’ll be stuck paying up to hundreds of thousand of dollars more in interest over time).. and this is only assuming you merely break even on the money you invested (and are not in the red).

I think everyone’s long term plan involves moving to a nicer house in a nicer area. This is something perfectly attainable by playing this situation safe. IMO, it is dangerous to put such basic life plans on the chopping block. I think this is how people could potentially get into serious trouble.

Now, don’t get me wrong. I’m not saying that you should immediately put any money you have towards prepayments, or you should put all your money down on that new house. I’m saying that you need to carefully balance this based on your confidence about making good investments and the amount of risk you are willing to take. In other words, I think its foolish for just about anyone to put very little down and not make prepayments when they can (i.e. tax return time, or portions of a raise). I think its equally foolish to put ALL of your money towards prepayment and down payment.

Make no mistake, that large down payment is a very good protection plan when you lose your job, your wife has a kid, or you encounter some medical emergency. Those lower monthly payments make things more manageable and prevent you from being overrun with debt.

A prepayment of only $300 a month on a $350,000 principal can save you well over a hundred thousand dollars in interest over 30 years. That money goes straight into your bank account or investments when your mortgage is paid off early.

These items are your safety net… and that’s part of good risk management isn’t it? To maximize gains and minimize risks. You can’t just focus on maximizing gains – you need to protect against potential pit falls as well.

By all means have your money work for you, and try to get investments that produce greater returns than your mortgage rate… but start off by minimizing your monthly payment (sizable down payment) and put a good effort in to pay your house off early (prepayments)… You know, just in case those investments don’t work out.

I have some questions of my own; let’s use Nick’s $300 per month example:

1. Is the $300 a month a sizable proportion of the amount that you intend to invest overall? If so, do you know what you are getting for it?

Nick says that paying down his mortgage by an extra $300 per month will save him $100,000 in interest over 30 years … let’s accept that number for now and assume that this $100k can be somehow freed up at the end of the 30 year period:

$100,000 in 30 years will have almost the same buying power then as $31,000 does today (assuming that inflation averages just 4%).

That should provide Nick a yearly stipend of just over $1,500 in today’s dollars (commencing in 2038, assuming that 5% can then be ‘safely’ withdrawn each year).

Now, there’s a problem right there; how can 5% be a ‘safe’ withdrawal rate in 2038?

If inflation is still just 4% Nick needs to find a ‘safe’ investment that will return him 9% after tax (4% to keep up with future inflation and 5% to spend) … he can’t get that return in retirement by paying down his mortgage any more, it’s already paid off!

So, now – in retirement – he has to look for a more ‘risky’ investment than the one he used to get there!

Therefore, I am assuming that Nick will either keep his paid off house and actually entirely forgo this income entirely or move into a smaller paid off house or unit to free up $100k of equity …

… in any event $1,500 or zero a month sounds pretty similar to me 🙂

2. Do you know what returns you can get elsewhere?

Even if Nick isn’t relying on this $100k (then why bother with it in the first place?!) – because he is also  investing elsewhere – what could he achieve if he also invested his $300 a month elsewhere?

Well, Nick is ‘saving’ 6% interest in the current market [AJC: if you aren’t prepared to fix an incredibly low interest rate like this, how can I help you?!], which could be equivalent to a 7.5% – 8% after tax investment return.

[AJC: Unlike investing in income-producing investments, there is possibly no income tax to be paid on your mortgage interest payments/savings … of course, there could be a tax disincentive if you have been itemizing your home interest on your tax return and can no longer claim that deduction]

But, what if he can find an investment that returns more than 8% after tax?

Even an extra 1% (after tax) additional return will improve Nick’s 30 year outlook by 20% (at least, for the $300 monthly extra that he is putting into his mortgage).

3. Do you care?

For me, this is the key question: can Nick achieve his financial goals even without investing this $300 a month elsewhere? If he can’t, is he willing to let these goals go for the apparent ‘safety’ of a home partly or fully paid off?

So, my real question to Nick is: can you achieve your financial goals at the same time as paying your mortgage off? It’s possible (hell, I did it!) but, for most people, not likely … they are already skating too close to the wind even before pulling extra money out of their investment portfolio.

To me, it’s the same thing as asking if you can fish for trout in a babbling brook without getting wet:

It’s possible, but you won’t probably won’t make a great catch unless you are prepared to (slowly, carefully, and not deeper than you can handle) wade in …

Your Perpetual Money Machine won't start?

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AJC has written his first article on US News magazine’s ‘alpha consumer’ web-site. It’s all about what US News calls Recession 2.0 … check out the article here then PLEASE leave a comment on the US News site!!!

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Your Perpetual Money Machine won’t start?

… then it probably just needs a little oil and a good kick!

I am, of course, talking about the Perpetual Money Machine that I covered in a series of posts last month. But, Caprica, who lives in Australia asks:

But not all perpetual motion machines are that seamless. If you want to invest in cash flow positive properties here in Australia, either you are buying into regional areas that are subject to seasonal trends or you become a slum lord. Furthermore, the boom on “cash flow positive” properties and the high interest rates here in Australia has meant that the cash flow positive opportunities have all but dried up.

Similarly, a Berkshire Hathaway portfolio can easily loose large chunks of value during declining markets (sub prime for example).

Is there a such a thing as perpetual motion machine (short of having more than 7 million in the bank earning interest) that means that I don’t need to deal with difficult tenants or worry about every jitter in the market?

Caprica is right, of course … not all Perpetual Money Machines are ‘seamless’, run entirely smoothly, or even start without a ‘kick’ in the right place!

But, start – and run – they will, if you do it just right …

You see, there is one ingredient that you need, Caprica, regardless of where you live: time.

Any reasonable property can become cashflow positive if you allow time for the rents to build up such that you ‘overtake’ the costs … in our analogy, it takes time for the ‘capacitors’ to build up enough ‘charge’ to kick-start our Perpetual Money Machine.

It helps if you can buy when the market is off its highs; it helps even more if you can lock in interest rates when they are still relatively low; it helps if you can put in your research and buy a property that will rent reasonably well and appreciate over time (but, we aren’t looking for ‘home runs’ in either category, here).

Similarly, stocks may go up/down, you just need to keep pumping money in (i.e. buying more stocks) until you have a buffer (excess of stocks) that will allow you to ride the waves and sell down a little at a time to live off (after you ‘retire’).

Equally, it helps if you have the fortitude to ignore the waves entirely -better yet, be contrarian – knowing that the inevitable ‘upwards correction’ will come ‘eventually’.

The Perpetual Money Machine will work anywhere, anytime … you just need to give it time to warm up properly 🙂

… a forced flight away from stocks!

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I wrote a post a while ago about the Myth of Diversification – just another piece of financial ‘wisdom’ almost designed to keep you form retiring early / retiring rich …

Yet, despite the current melt-down that should prove that there is no real safety in diversification, the principles remain as mainstream as this comment from Francis illustrates:

That’s the idea behind diversification and re-balancing. If you invest in multiple things and periodically adjust the balance between them you are forced to buy low and sell high.

It really doesn’t take a genius to make a few million if you can just buy low and sell high …

… but, it takes genius to know when to buy low and when to sell high!

Who knows where ‘high’ and ‘low’ really sit: they are relative, which serves (partially) to explain why market timing doesn’t work!

As the Dalbar Study shows:  mere mortals should not be in the business of trading stocks / timing the market; people who attempt this reduce their returns from 11.9% to only 3.9% … !!

No, we are simply investing for the long term, that’s why I asked Francis:

I agree with the “buy low” part … but, why “sell high”? Warren Buffett got rich by not selling his winners … he holds on to them.

Quite rightly Francis responded by pointing out that we aren’t Warren Buffett, saying:

Another reason to sell is that there are bubbles where the valuation of particular resources is out of whack. Wouldn’t it be a good idea to sell off at some amount before the peak of the bubble then repurchase after the crash? If you could reliably time the market you would sell it all at the peak and buy at the trough. I don’t have a crystal ball and I’m terrible at market timing. I’ve accepted rebalancing as a reasonable compromise.

As for Warren I know his favorite holding period is forever, but he is buying individual companies and is really good at valuing companies. He avoided the internet bubble like the plague, but I suspect that if he had stocks that became wildly valued he would sell them off.

But, if we really aren’t Warren Buffett, how do we KNOW when “the valuation of particular resources is out of whack”? Well, according to Francis, that’s when ‘rebalancing’ comes into play …

But, how does re-balancing provide a ‘reasonable compromise’ to the fact that we are all (WB aside) “terrible at market timing”:

Let’s say that you have $100,000 invested: 50% of your money invested in stocks and 50% invested in bonds.

Let’s then say that stocks ‘devalue’ by 50% overnight (a huge market crash) … in the case of an Index Fund, this could simply be a cyclic response to the market that has occurred many times in history.

Suddenly, your portfolio has shrunk by $25,000, so now you have $25,000 worth of stocks at post-crash prices and $50,000 worth of bonds (their price/value hasn’t shifted in this hypothetical crash). That is, you have 33% in stocks and 67% in bonds … so what do you do?

Well, you buy $25,000 more stocks … or, do you sell $25,000 of bonds?

The reality is that most people don’t have the $25,000 in ‘loose change’ to rebalance by topping up their portfolio, so they shift money FROM bonds INTO stocks.

Yippee … except, what happens when stocks recover and/or bonds dip?

In that case, you’d be taking yourself OUT of the stock market (a 9.2% – 11.9% annualized return, depending on who/how is doing the measuring) into the Bond market (a 4% annualized return?) …

… a forced flight away from stocks!

Would Warren Buffet do this?

Heck no! Warren Buffett doesn’t worry about market dips; he knows the market always recovers, as long as the underlying businesses keep making money. In fact, he looks at market dips as a buying opportunity (didn’t he load up on Kraft, while we were all bailing out of the market).

He identifies quality when he buys (bet he didn’t own any Enron), but, he recommends that you buy a little piece of all of America’s finest companies (a.k.a. an Index Fund, so even if you do happen to buy Enron, it’s only a tiny sliver of what you own), if you don’t know how to do what he does.

Warren doesn’t ‘rebalance’ his portfolio into cash (no dividends even, because cash/bonds doesn’t produce as high a return as his investments can) … and, he certainly buys more when the market dips and NEVER sells.

Here’s what to do:

If stocks are the asset class that you like and if you think that the stock market (as represented by an Index Fund or one or a few individual stocks, if you prefer) represents acceptable value:

1. Buy stocks … as many as you can afford; and,

2. Keep buying whenever you can afford more; and,

3. When the market dips, it’s ‘on sale’ … buy even more; and,

4. Never sell.

That’s it … now you are Warren Buffett.

A random walk in the financial park …

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I’ve looked high and low and I’ve finally found it!

‘It’ is the source document for all of the commentators who have (rightly) suggested that Index Funds outperform actively managed Mutual Funds.

And, it is produced by Standard & Poors who publish the major Indices themselves:

The Standard & Poor’s Index Versus Active (SPIVA) methodology is designed to provide an accurate and objective apples-to-apples comparison of funds’ performance versus their appropriate style indices, correcting for factors that have skewed results in previous index-versus-active analyses in the industry.

And, here are their most recent findings (they are in the process of rebuilding their databases for 2008):

Indices continue to exceed a majority of active funds. Over the past three years (and five years), the S&P 500 has beaten 65.7%   (72.2%) of large-cap funds, the S&P MidCap 400 has outperformed 68.6% (77.4%) of mid-cap funds, and the S&P SmallCap 600 has outpaced 80.2% (77.7%) of small-cap funds.

The solution is simple: don’t buy any of the funds in the bottom 65.7% 🙂

Great! But how?

Well, Mutual Funds are rated by Morningstar as 5-Star (best performance) to 1-Star (worst performance) so, we should simply buy 5-Star funds, right?

Wrong … because Morningstar – even though it is the best / most highly regarded of all the Mutual Fund ratings services – is only based upon past performance, which is NO guide to how any rated fund will perform in the future as this independent research review found:

They find, for example, that five-star US equity funds significantly outperform one-star funds only 37.5% of the time; at the same time, these same funds significantly outperform three star-funds 18.75% of the time. It is clear then that—compared to a random walk–Morningstar’s ratings system offers no added value in terms of predicting mutual fund returns.

If the best can’t do it, do you think you can?

And, do you want to leave your financial future to a ‘random walk’ in the financial park?!

So, why do funds tend to fall short of the ‘market’?

Well, partly because of a tendency to trade stocks too much (the fund managers like to ‘look busy’) and partly because of fees … Mutual Funds tend to fall short of the market by the amount of the fees that they charge!

The ‘small moral’ of the story: invest in the Indices …

… find a low cost Index Fund that will do the job; by as much of it as you want and hold it for the long term.

Of course, the ‘large moral’ of the story is: who the hell is content with 11.9% maximum long-term stock market index returns, anyway 😉

To cap off the week …

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I can’t think of a better way to cap off a week’s commentary on the current financial meltdown than to 100% plagiarize this letter to the New York Times – it’s by none other than Warren Buffett …

… so, read carefully as to what a conservative guy who has almost 100% of his PERSONAL assets in nice, safe government bonds is doing right now.

[AJC: I was going to highlight the critical sections for you, but it’s ALL critical, so if you just want to give it your usual 27 second scan, that’s your problem 😉 ]

October 17, 2008
OP-ED CONTRIBUTOR

Buy American. I Am.
By WARREN E. BUFFETT

Omaha
THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So … I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities. [Warren E. Buffett is the chief executive of Berkshire Hathaway, a diversified holding company]

’nuff said 🙂

Making Money 101? What to do today!

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I write about advanced financial strategies; these are designed in three stages: Making Money 101 – Get on your feet, financially speaking; Making Money 201 – Build your wealth; and, Making Money 301 – Keep your wealth.

Another way to look at it is that my blogs are all about getting you to your Number, then keeping you there!

Since we are dealing in time-frames of years (at least 7 years to go from ‘zero to financial hero’) we have to expect to deal in all phases of market cycles – both the up’s and the down’s – so I avoid talking about specific ‘today’ strategies in favor of the longer-term.

However, my son has said that I need to help people through the current financial ‘crisis’, so that’s what I am going to do over the next 3 days:

Today, advice for all those Making Money 101 …

Wherever your money is right now, keep it there!

That’s it, thanks for reading 😉

Oh, you want details?!

OK, here it comes:

– If you are currently in cash, stay in cash.

– If you are currently in stocks or mutual funds, stay in stocks/mutual funds.

– If you are currently in real-estate AND can afford the payments and are not ridiculously in credit card and other consumer debt, stay in real-estate.

Why?

Well, as this post explained, over the long run, you will achieve the market averages for all of these investment choices … only if you stick with them through thick and thin.

Right now qualifies as being about as ‘thin’ as anything in the last 100+ years 😉

If you run away during the bad times (now) and only buy in the good times (2006) you will be buying high and selling low: the exact opposite of what you should be doing …

… then, you will be lucky to make 3% or 4% annual returns – the same (or less) than if you had kept your money in cash!

So, for those MM101’ers out there, what are you doing with your assets while the financial world seems to be crumbling around you?

The time of your life?

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It’s interesting that I drafted this post 3 or 4 weeks ago, just before the current wave of stock market crashes hit us; now, of course, I am ‘preaching to the converted’ …

We spoke about getting – or beating – average returns from either stocks or real-estate, but David points out: what is an average financial return?

I agree with you about the number. However, think you should use real rates of returns not some theoretical possibility. For example your number on mutual funds is 9.5%. Well actual rates of returns for individuals investing in mutual funds averaged 4.4% over the last 20 years (Dalbar, Inc. Vanguard, etc.).

So, what are the average returns for the stock market?

First, define the ‘stock market’:

Do you mean the US market? International (if so, which country or countries)?

If US, do you mean large cap (the stocks with the largest total stock market value or ‘capitalization’)? Or, small cap? Or, do you mean stocks listed one one of the alternative exchanges such as NASDAQ?

Or, do you simply mean ‘all’ stocks listed on the New York stock exchange (NY Composite), or ‘only’ 5,000 stocks (Wilshire 5000) or perhaps ‘just’ 2,000 of the listed stocks (Russell 2000)?

If ‘large cap’ do you mean the top 500 stocks listed on the NY stock exchange (S&P 500) or perhaps the just the largest 30 (DJIA)?

The point here being that there is no such thing as an ‘average return for the stock market’ … you have to decide how you want to slice ‘n dice it first!

Semantics aside, let’s pick an Index – say, the S&P 500 – how has it performed?

Pick a Number!

Here is data taken from Econstats.com and summarized here into the average returns of the S&P 500 for various 10 years periods from 1989 – 1998 through to 1998 – 2007:

10 years too short?

OK, let’s find an online calculator and see how the S&P 500 performs over various 25 year periods:

In case you can’t read the diagram:

The best 25 year return (since 1871) for the S&P 500 was 17.6%, but the worst was 3.1% .. yah think that might make a difference if you your whole damn retirement strategy was hinging on achieving ‘average’ returns?!

BTW: If, you were ‘lucky’ enough to get the average, it was 9.4% …

… but, here’s the problem:

In ‘real life’ people don’t get the average!

Firstly, they rarely choose the S&P 500 … they usually gamble on just one or just a few Mutual Funds that used to perform better than the market (but, rarely ever do again).

Secondly, they pay fees that knock down returns by an average of 1.5%.

Thirdly, even if they do buy into a low cost Index Fund that tracks (say) the S&P 500, they actually rarely stay the course for the full 25 years (take another look at even the 10 year chart, above, if you want to see what that can do to the reliability of your returns).

Don’t believe me?

Check out the Dalbar Study

… then, scroll all the way back to the graph at the very top of this post:

Pictures really do tell more than a 1,000 words 🙂

What is risk?

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Jeff raises a great question about the nature of risk; he is talking specifically about real-estate investing when he says:

After reading a couple books, it looks like the majority of the return comes from leveraging your money and keeping your money leveraged over your holding period. Also, reinvesting your cash flows into another investment (instead of living off of them) adds additional compounded return over the long haul. These, however, dramatically increase risk…but, no risk, no reward.

Now, I need to make a point right here: I talk about real-estate (RE) investing a lot … and, I certainly made a lot of money in RE … so, it follows that I am in love with RE, right?

Actually, no.

I hate investing … I dislike real-estate … I abhor risk …

…. it’s just that I hate NOT investing even more. Seriously.

I have a lot of money sitting in the bank earning interest (an excellent rate, if I may say so myself); but all I can think of is that it’s not working fully for me … I am not anywhere near maximizing my return. Where’s the capital gains?

In the bank, there is none.

So, I am FORCED to look elsewhere to invest, and I inevitably end up back at real-estate. I do it because, for me, it represents the best risk/reward trade-off that I can find … IF I am certain that I can cover the cash flows if things go south for a while (repairs and maintenance, loss of tenancy, etc.).

Jeff is absolutely right about RE’s ability to get returns ” from leveraging your money and keeping your money leveraged over your holding period”.

But, back to Jeff’s questions about risk: when Jeff says that leverage = risk, he is technically correct but absolutely incorrect.

Let’s take a look at the technical nature of risk:

Case 1 – RE v CD

We compare the risk of investing our $100k into a $100k piece of real-estate (no borrowings, and for the sake of the discussion no closing costs) v. into a bank CD and we realize that the piece of real-estate and CD produce differing rates of return: according to common wisdom, slightly above inflation for the RE and about even with inflation for the CD.

But, the RE can burn down, lose a tenant, etc. etc. Of course, on the plus side, you can rehab the property cheaply and increase returns; choose better tenants; find a high-growth area; etc.

The CD is fully government-insured (hence the $100k limit for this exercise); and, you can look around for the best CD deal (from an insured bank!) in town.

Bottom line: Slightly different rates of return, markedly different risks.

Intuitively, we understand that there is a relationship between risk and return and the RE v CD example illustrates that in a way that we can all understand.

Case 2 – RE v RE

Let’s say that you decide that the better return from RE is worth the increased ‘risk’.

RE can be leveraged; so that must increase risk? Again, technically ‘yes’, but let’s look at it in practice:

0% leveraged RE v 100% leveraged RE:

If the ‘sub-prime crisis’ didn’t show the risk (not necessarily the folly) of ‘no money down’ RE deals, then we may as well stop the discussion right here, because we all know that fully-leveraging a property is much more risky than owning it outright (it’s why we pay down our home loans, right?)

But what about 0% leveraged RE v just 20% leveraged RE?

Does that seem a lot more risky to you? If not, what about 0% leverage v 40% leverage … and so on.

In other words, risk is also personal: once you decide to invest in an asset class – say, RE – there is no magical point at which leverage becomes ‘risky’ or ‘not risky’ (unless you were one of the people who thought that 20% leverage was ‘risky’).

The point here is to show that whilst there is indeed technical risk, it can be highly subjective and frankly far less important to your financial decision making than ‘absolute risk’ …

Absolute Risk

To put this in perspective, we all know that trying to jump over roofs between buildings is risky. Much more ‘technically’ risky than going through the fire doors, down the fire-stairs, into the street, then reversing these steps in the next building …

… but, if you are Jason Bourne and a CIA Operative is coming through the doorway behind you with a BIG GUN (did I mention that you were out of bullets?) to ‘take you out’, don’t you think that you just might suddenly ignore the ‘technical risk’ and jump across anyway (if you thought there was any reasonable chance that you might make it)?

Instead you might decide to try and surprise the armed assailant with a karate chop (what is the ‘technical risk’ of karate chop v armed assailant?) … in other words, you mostly ignore ‘technical risk’ because the ‘absolute risk’ of failure is too great.

Equally, financially-speaking, ‘absolute risk’ is the only risk that really matters; it simply asks:

What is the risk that [insert preferred method of investing here] won’t be enough for me to make my financial goals i.e. my Number /Date?

If putting your money in a bank CD that earns 4.5% gets you to your financial goals, then that’s probably what you will/should do.

But, if it won’t what do you do?

It all depends on how important your financial goal really is, doesn’t it?