There is always the latest financial guru who claims to hold the key to guaranteed high returns. The real secret to successful investing is to keep in mind the simple high return/high risk rule and you will never go wrong.
You can lose money if you invest in anything other than safe inflation protected bonds. And if you’re investing in something that promises a bigger return than the broader market, you’re agreeing to a bigger possible downside.
This should be the first thing people absorb when they learn about personal finance and start investing. But for some reason (greedy?), it’s often ignored even by people who work in finance. Understanding the risk/return trade-off is also the best way to protect yourself from financial fraud. If someone promises they can beat the market, one of three things is true: they are lying, they don’t know what they are doing, or they charge very high fees. and not worth it.
The fact that there is no free lunch in finance underpins modern monetary theory. That’s true no matter what new innovations appear before us, such as high-frequency trading or blockchain. Just look at the last few years. In 2020, it looked like anyone could beat the market. or technology stocks). There were also many people on TikTok offering advice on how to pick a sure winner.
Everything that looked great in 2020 and 2021 is now underperforming. Since January last year, the S&P has fallen 20% of his. But taking the extra risk and betting on technology reduces the portfolio by 45%. 64% drop if you buy cryptocurrency. The only asset class that claims to be doing well is private equity, but it’s also less liquid and has a lot more room for funds to calculate returns (because it’s not marketed), so it’s also riskier. High returns are real.
And it’s usually like this. The riskiest investments tend to do well in bull markets and worse in bear markets. A bear market is the worst time to lose money. So if an asset you have invested in is performing better than others, it may not be because you made a big bet, it’s just because you took more risk.
But we easily forget this hard truth. Probably because many of us know someone who got rich on cryptocurrencies and sold at the right time. That’s the nature of risky markets, and if you time it right, you can get ahead, but getting the timing right is rare, and if you do it once, you may never do it again. Many of those who called for the 2008 financial crisis have never had a repeat of their success or fortune.
Having established a simple risk/return rule, it is important to understand that there is nothing wrong with taking on more risk. That way you can probably get higher returns over time. High risk does not mean large losses are inevitable. It’s just less certain. The problem is, whether it’s the housing bubble, the FTX cryptocurrency exchange, hedge fund Long-Term Capital Management LP, or any other financial disaster, people take a lot of risk and present it as a risk. (or mistakenly misinterpret it as a risk). -freedom.
If someone thinks they have a risk-free bet to beat the market, and in order to get an even bigger profit, they borrow to finance the “sure thing” and take advantage of the extra leverage, the big financial bankruptcy will occur. Leverage magnifies all returns and losses, so when a “sure thing” loses money, it can be catastrophic. Even leverage isn’t inherently bad. The real problem is to think that something that is actually risky is not risky and then double or triple (or more) that bet without considering the potential downside.
Anyone in financial services should be familiar with it, but very few actually do. Perhaps it’s because you tend to think you’re smarter than everyone else, and if the market is going up and your portfolio is going up, you might look like that. But that’s not true. If you are beating the market, you risk taking a bigger loss, which can happen in the worst case.
If you can afford that loss and have the guts to weather the market, it can end up being a worthwhile trade-off. If you pay for advice, it should be for risk management and retirement planning, not for beating the market.
Think balance if you want to do it yourself in 2023. Take some risk, but don’t take undue risk. For most of us, that might mean an index fund that invests in many stocks and charges low fees. To do. Even after the 2022 bear market, the S&P 500 is higher than he was three years ago. The same is not true for many of the riskier investments.
More thoughts from other Bloomberg writers:
• Will cryptocurrency be a safe investment?: Andy Mukherjee
• The Fed has a Greenspan conundrum: Robert Burgess
• Navigating 2023 with 7 Charts and Cats: Ashworth & Gilbert
This column does not necessarily reflect the opinions of the editorial board or Bloomberg LP and its owners.
Alison Schrager is a Bloomberg Opinion columnist for economics. A Senior Fellow of the Manhattan Institute, she is the author of “An Economist Walks Into a Brothel: And Other Unexpected Places to Understanding Risk.”
More articles like this can be found at bloomberg.com/opinion.