Friday, June 18, 2010

High Returns, Low Risk! (or Financial Porn?)

On the cover of a recent issue of a major national financial magazine, written in big block letters was: HIGH RETURNS – LOW RISK. This is a blatant example of what many financial authors refer to as financial pornography. I already discussed my disdain for most financial news in my February 2010 post Financial News: Worse than Useless!, but this headline was so appallingly ridiculous that I couldn’t resist commenting on it.

One of the most axiomatic principles of investing is the relationship between risk and reward. Investments that are perceived as higher risk have higher expected returns. Expected return is a bit of a misnomer: it’s not really the return we expect, but in comparing investments, we can think of it roughly that way. For example, over relatively long periods of time, investors in general expect to receive higher returns from stock investments (riskier) than from bond investments (less risky). You simply cannot find investments that provide high returns with low risk.

Not only does academic research support the risk/reward relationship, but it’s just common sense, as well as basic supply and demand. Think about it this way. If investors believed investment A would provide higher returns at lower risk than investment B, then they would rush to buy investment A and sell investment B. The higher demand for investment A would drive up its price, and the lower demand for investment B would drive down its price. This behavior would continue until the price of investment A was high enough (and B low enough) that it no longer presented such an obvious reward to risk superiority over investment B. Although markets may not be perfectly efficient, they are highly efficient; i.e., information is quickly disseminated and acted upon by professional investors. By the time you hear about investment A, the probability that it’s still a great deal (even if it ever was) is basically zero.

So, if you ever read or hear anything promising high returns with low risk, please be aware that the purveyor of this message does not have your best interests in mind. They are trying to sell magazines or newspapers, or trying to get you to watch their show or read their web site so they can sell their advertising, or trying to make a commission by selling you an expensive investment product.

Please understand that I’m not making this stuff up. Most of the investing books on my recommended reading list cover this and all the other topics I write about, and these books are based on academic research. If you’re concerned that the recommended books may be biased, then get a basic textbook on investing such as Essentials of Investments (7th edition) by Zvi Bodie et. al. I got a used copy (in excellent condition) of this fine textbook from abebooks.com for $10.49 including shipping. You will be much better served spending your time reading a book or two based on academic research than reading the financial pornography that is so abundant yet so counterproductive to your investment success.

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