One thing that I hear constantly in investing circles, even from some people with investing education, is that you cannot get above a certain return, typically around 4%, without the investment being risky or [cue the gasp] illegal. This statement is often followed up with someone saying that 2% returns are very safe.
These statements/beliefs held by our culture drive me NUTS because they are completely & utterly FALSE!!! We as a society believe that low returns are automatically safe and high returns on automatically risky, and nothing could be further from the truth. While it is true that sometimes high risk investments have high returns and low risk investments have low returns, the return itself does not make the investment risky or safe, rather it is how the investment works that makes it risky or safe. The truth is that it is completely possible to have a 2% return on investment that is unbelievably risky, and also have a 35% return on investment that is extremely safe as will be shown later.
It’s How it Works that Matters
I think that the reason for this misconception is that people do not understand how investments work, so they simply see the end result and make their assumption of risk on that. This method of analyzing investments would be the same as saying that a car engine with 600 horsepower is super “risky” and could easily blow up at any minute while saying that an engine that has 5 horsepower is super safe and has no chance of blowing up simply because of the horsepower amount without taking into consideration the quality of the engine, how it was made, who made it, how it works, etc. Likewise, investments are not risky or safe simply because of the yield that they produce, but because of how they work. (Side note, I wrote a little more extensively on the importance of knowing how investments work a few months ago if you want to check it out).
Risky 2% Investment vs. Safe 35% Investment
If you don’t believe me that a 2% return can be risky, imagine if someone, whom you knew to be untrustworthy, asked to borrow $1,000, and this person promised you a 2% return, but the way that he was going to give you that 2% return was by buying lottery tickets with the $1,000 and giving you the 2% from any winnings that he MAY collect. All of a sudden, that 2% return does not look safe at all, in fact, it is as far from safe as one can get. The point is that the risk comes from the underlying mechanism that drives the investment. Once one understands the mechanism, as well as the person driving it, it is obvious that the prior investment example is faulty.
OK, so we have seen how a 2% return can be risky, now let’s look at the other side of the coin, how can a 35% return not be risky? Here is an example, let’s assume that our friend Jean Claude owns a car that he insures with a reputable insurance company. Let’s assume that the company has an offer that says that if Jean Claude pays for 10 months in advance, that they will give him two months of insurance for free. In other words, Jean Claude usually pays $100/month, but if he pays $1,000 up front, he will get credit for a full 12 months. Jean Claude decides to take them up on this offer and pays the $1,000 up front. What is Jean Claude’s return on investment (“ROI”) from doing this? To answer this question, we need our trusted financial calculator, so let’s get to work.
Answer: (Enter the following numbers into you 10bii financial calculator. If you don’t have one, no problem, simply follow along)
N (Number of Months) = 12 (The entire situation lasts for 12 months as Jean Claude pays $1,000 today and gets credit for the next 12 months.)
I/YR (Interest Rate/year) = ??? (This is what we are solving. We want to find out what the interest rate is on the $1,000 invested today.)
PV (Present Value) = ($1,000) (This is the amount that Jean Claude “invests” today by paying the insurance company. Notice that it is negative as Jean Claude is losing access to the cash today to get the credit for the next 12 months.)
PMT (Monthly Payments) = $100 (This is the credit that Jean Claus receives every month by paying the $1,000 up front. Consequently, for the next 12 months he does not have to pay $100/month but he is treated as if he does. This is the part where people often struggle as people think the answer should be $0 as he is not receiving any physical cash during the 12 months. However, we have to look at Jean Claude’s benefit that he receives, not just the physical cash. He normally has to pay $100 every month, but because he paid $1,000 today and in return every month he does not have to pay $100 for the next 12 months, but he is still getting the credit for each of those months as if he is paying it. So, he is receiving $100 in credit every month.)
FV (Future Value) = 0 (At the end of the 12 months, there is no big balloon payments made.)
After entering these numbers above into your financial calculator, the answer comes out to 35.07%!!!!!!! Meaning that if Jean Claude took advantage of this offer, it would be the equivalent of him receiving a return on his investment of over 35% on his $1,000.
Put in a 3rd Person
That is not a misprint, the return on investment for Jean Claude in this deal is 35.07%. Now I know what some of you are thinking, “This is not really an investment, this is more like a savings that he is receiving.” In response to that, I would ask you to put a 3rd person into the equation. What I mean is, what if Jean Claude went the bank and said to the banker, “I would like to invest $1,000 with your bank, would you please give me back $100/month for the next 12 months?” What would the banker say? The banker’s first response would likely be, “You are insane!!!! How about I give you a 1% CD, which would give you $83.79/month, that works out much better.” The banker in this situation knows that the return would be 35%.
Well, for argument’s sake, let’s assume that the banker ultimately agrees to give Jean Claude the $100/month for 12 months if Jean Claude invests $1,000 today. We can agree that the return that Jean Claude would receive in that situation is 35.07%. Now, let’s take this a step further. Let’s assume that Jean Claude asks the banker, “Instead of giving me the $100/month, can you please simply pay my car insurance directly for me as it saves me the hassle of collecting money from you then cutting a check for the car insurance company (this assumes that Jean Claude did not take the deal with the insurance company)?” This scenario gives Jean Claude the EXACT SAME NET EFFECT as if he took the offer directly with the car insurance company without involving the bank. He pays $1,000 up front and gets his insurance paid for the next 12 months.
3 Important Lessons
I think that this example shows three very important lessons:
- Investments are often right under our noses. It is imperative for people to look at anything and everything as a potential investment. When the vast majority of the population discusses investments, they believe that the only investments are stocks, bonds, real estate, mortgage notes, etc. This limited belief that “investments” can only be a certain type of asset is hindering people as it starts them on the limiting mentality that they have to play in the “box” to be able to invest. So, it is important to always be looking for other forms of investments that are out there, and often those investments are right under our noses.
- It does not take a lot of money to invest. I often hear people say that they will start to think about investing when they have $XX,XXX saved up in the bank, but before then they can’t even think about it because it is out of their price range. However, there are plenty of investments that do not require a lot of capital up front. This type of investment discussed above does not require one to have a ton of cash, analyze a complicated spreadsheet with a bunch of numbers and letters that no one understands, or pay someone in a tie a commission to do the work. Rather, this is a simple investment that will give someone an amazing return on their money and that is available to everyone right now.
- There exists investments with amazing returns that are not risky (or illegal 😉 The example above it is a pretty low risk investment that does not require a thousand different things to happen to get the 35% return. Granted, there is some risk as the insurance company could go out of business or Jean Claude could get rid of his car, but those risks are small. When one examines the mechanism that works to create this return, it is easy to understand and easy to see where it comes from, and most importantly, easy to see the potential risks.
In summary, I think that this simple example sums up the importance having a strong investing education. This example with a amazing return does not require a certain degree or a ton of money, rather it requires a knowledge of cash flow and how it works and the desire to “hunt” for these investment opportunities, wherever they may exists (sometimes, they exist in places as boring as one’s budget). If you are interested in other ways to get amazing returns, check out my recent blog on real estate investing and my recent blog on mobile home investing.
In closing, just because something has a low return does not mean it is safe nor does a high return mean it is risky. Rather, one needs to look “under the hood” to see how the investment works to see the true risk.
After reading this example, what are your thoughts? Can you think of any great investment opportunities right under our noses? Feel free to write your feedback below.
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