Behavioural finance has an increasingly central part in conversations about investment risk, since managing emotional responses plays a key role in maximising returns.
Investing is about putting money into something in the hope that you will get more money back. Whether or not you get your money back is called “risk”, and without taking risk you cannot make money in the financial world. This is a basic rule: there is no free lunch. Generally speaking, to make more money you have to take more risk.
Think of investing like being a farmer. The farmer plants certain vegetables or fruits and, after some time, he/she can harvest the yield and make a gain. However, there is also risk if bad weather permeates: the plants don’t grow, and there is no gain. This is why the farmer needs to spread his/her risk, e.g. by keeping livestock or growing plants that need different types of weather to grow. This is called diversification, and it simply means don’t put all your eggs in one basket.
Vegetables don’t grow by accident, they must be planted, watered, and harvested. This costs time and money for equipment or labour. Therefore, also when making investments, you must watch out for the costs – and there are many fees and expenses in the complex world of finance.
Nobody can predict the future, so we also don’t know which investments will do better than others. All we can do is assess how risky they are.
The other thing you want to do is to avoid doing something stupid, and that means not trying to be too clever. When things seem too good to be true, they usually are and making guesses about how things will turn out is to be avoided. Nobody can predict the future, so we also don’t know which investments will do better than others. All we can do is assess how risky they are. The more risk, the higher the expected return, but nothing is for certain, least of which the future.
The first thing you want to do, is to think about how much risk you can or want to take, e.g. are you prepared to lose some of your money, most of it, or maybe even all of it? For most of us, this is a question of income. We all have bills to pay or things we need to buy, and there needs to be enough money coming in to meet these so-called “liabilities”. Because this is so important, this is where it starts: making sure we cover ourselves. This means that some of our investments must give us high assurance that we not only get our money back, but we also receive something on top. The best way to achieve that, is by lending our money to someone else for a specified period of time. In exchange, we receive interest which is based on the ability of the borrower to pay us back.
There are three ways in which we can speculate on price: the price that we bought something for goes up (absolute); speculate that the price is higher than something else (relative); or that the price reaches a certain level (specific)
Once our liabilities are covered we can take more risk, to make more money. Making money is all about the price at which we buy and sell our investments. There are three ways in which we can speculate on price: the price that we bought something for goes up (absolute); speculate that the price is higher than something else (relative); or that the price reaches a certain level (specific).
In the financial world, there are many different strategies that enable us to take these different types of price risks. This can be rather confusing, not only because there are thousands of different investment products, but they also have different names and classifications and, of course, they are also being sold under different brands. The important thing to remember is, that understanding the type of risk of the underlying investment is what matters, not what someone is telling you it is. In other words, if you buy a can of tomatoes, make sure there are tomatoes inside. And finally, only if we spread our investments across all four types of risk are we truly diversified.
Investing is like walking down a dark alley, late at night and everyone is out to get you. Investing is also called a zero-sum game, e.g. for someone to make a gain, someone else must lose. If you buy something at 100 and it goes to 120, then you make 20, but the person who sold it to you at 100, has lost out on making that 20. It is brutally efficient, which is why you cannot trust anyone, least of which the people that promise you things that you know they cannot deliver. Remember, no one predicts the future, and that includes all those smart, educated and experienced financial professionals who are trying to sell you their products and services so that they can make their gains.
Once you accept that pigs don’t fly, and you lose your fear of missing out on the next big thing, investing can be the most rewarding thing you will ever do. After all, your money is doing the work for you and if you play your cards right, and that means spreading your risk and keeping your costs low, Father Time will take care of the rest.
After all, your money is doing the work for you and if you play your cards right, and that means spreading your risk and keeping your costs low, Father Time will take care of the rest.
Time literally is money and if you keep investing more of what you have made, more becomes more. This is called “compound interest” and is sometimes also referred to as the eighth wonder of the world (Albert Einstein). It works like this: say you invest 100 and you make 10% in a year, or a return of 10. Then the next year, you can invest 110 and if you make 10% again, then your return is 11. And the year after that it is 12.1, and so on. Letting your money work for you means letting it grow, and that is a beautiful thing.
We help our clients understand the risks of the particular investments they want to make. We have much experience and expertise from having developed a strategy for our families’ wealth that applies all the lessons learned, and follows the rules as laid out in this document.
Foremost, we act as an independent counsel and we guide our clients by sharing our philosophy, systems and processes. We don’t make promises we can’t keep, we do not try to predict the unpredictable and we take things for what they are. We may not know where things are going to go, but we can control how much our investment is going to cost and how much risk we are going to take. That focus is our advantage for the benefit of our clients.
If you would like to start a conversation with Blu Family Office, please get in touch with our expert team.