By Professor Ricardo Ulivi, Ph.D.
You often hear the phrase, “To make money, you need to take risks”. Indeed, modern finance has proven that there is a positive relationship between risk and expected returns. That is, the higher the perceived risk of an investment, the greater the expected profit. But notice the word “expected.” This means that taking risks does not guarantee a higher profit; it only means that if you consistently take risks that have high expected returns, you should earn more than the investor who is risk averse.
What is risk?
Risk can be defined as uncertainty. That is, when you are not sure what the outcome of a particular investment might be, that’s considered risky. For example, you buy a stock because you feel it’s going to go up, but it could also drop. That’s a risky investment because we dn’t know for sure what will happen.
Do you need to take risks in order to make money? Not necessarily. You just have to be convinced that the opportunity you see is real, and not a mirage. It’s like falling in love. It’s hard to define, but when you feel it, there’s no question! The difficulty in making this type of investment lies in the fact that most people will not see what you see, so they may think you are making a big mistake. And that could result in your failing to pull the trigger. Self-doubt is very damaging.
Let me illustrate the psychological difficulty in picking great investments through an interview with a Stanford professor and successful venture capitalist, Andy Rackleff.
You make money when you are right and there is no consensus
Professor Rackleff basically said that when making an investment, there are four possible outcomes: you can be either right or wrong, with consensus or without consensus. If you are wrong, you don’t make money. If you are right, and that’s the consensus view, you don’t make money either, because the price of the asset would have gone up to reflect the consensus view. Therefore, the only way to make outsize returns is to be right when no one else believes there’s an opportunity to make a large profit. You have to foresee what others don’t, and you have to withstand the pressure you will feel when others tell you that you are making a mistake!
Want to make an investment to earn 8.75%?
Here’s a real example of this dilemma. Right now, I “see” a great opportunity in a bond that pays over 8% per year. I believe that the fundamentals are so strong that the investment will turn out to be an excellent one. Yet, the consensus view is that it’s a very risky. That negativity is exactly what makes this investment so promising. Call me and I will tell you more about it. Most likely you still won’t believe it is a great opportunity, and that’s what proves Professor Rackleff’s theory: to make money, you have to be right and the consensus view has to be wrong.
Contact me at 714-771-6000 about this investment or if you need help with your personal finances, investing and/or retirement planning.