Most people in my close circle thought I was crazy when I made the real-estate investment, but for me, it made perfect sense. the most associated factor with investment is Risk and I used to say that risk and beauty are the same; in a way, both are in the eye of the beholder.
Over the years I developed a simple framework to think about the factors of investments and shape the complicated models into a simple personal one. The basic framework that I came with is based on four factors:
In this article, we will cover two of the four factors of this model: Risk and Return.
Let’s start with Risk. There are a lot of definitions for risk but I want to divide it into two simple definitions:
1.Absolute Risk- the probability of losing the initial capital/Principal
2.Relative Risk- the probability of achieving different returns than expected.
The best investors are focusing more on Risk than on the Return, which requires great discipline. Over the years, I have read a lot of what Warren Buffet wrote, but his golden rules are :
1.Never Lose Money
2.Never forget rule number 1
I personally belong to the side who thinks that risk and return are not always correlated. the higher the risk, the higher the return is not always true.
So every person should ask themselves: can I deal with total risk? Can I stand losing the initial capital that I worked so hard to save? In this case, maybe they should not have their money in stocks, but rather stick to treasury bonds.
For the purpose of our discussion here, let’s say that “high risk” is an absolute risk which means you could lose some or all of the initial capital invested. “Low Risk” is relative and means that the chances of losing your initial capital are very low but you could get a different return than expected.
The last thing I wish to emphasize about risk is the fact that risk could change for some investments over time. The risk of a bond — or every loan, for example, can vary greatly, from right after it is issued compared to the time before it will mature. near maturity, the borrower already paid most of the interest and there is a better chance they will pay the principal too. Another example will be -Startup investment. The risk at the beginning when you are writing the first check for the startup is much different than the risk after the 4th or 5th round of funding. The startup is less fragile after its 4th round.
I think that a good rule of thumb for risk assessment for every person should also be in the context of their financial safety net. If I invest and lose all of it, do I need to change my standards of life (sell the house, rent a trailer and park it at your parent’s backyard, stop eating)
To summarize the Risk framework:
Now, we can move to the “fun” part that we all like to think about: Return.
I like to think about Return in two main categories; The first is the quantity and the second is how you are being rewarded.
1. With the Quantity, the simple distinction is between Absolute and Relative.
2. With how you receive your reward the options are Value and Cash Flow.
Some people will prefer a lower return but monthly cash flows over a higher return and only value appreciation, while others will prefer the opposite. Preferences can also change in a person’s life due to circumstances.
We also have to say something about people economic behavioral bias; For example, retirees will prefer drawing cash-generating investments over executing the 4% rule of drawing yearly from their investment portfolio, even if they will get a solid proof that it’s affecting their total capital in the same way.
Another point to think about is whether -at this point in your life — you can “enjoy” the mere knowledge that the value of your investment is going up, or do you have to get some monthly or quarterly reward in the shape of ‘money in the bank’. Ask yourself the same question when you can’t see the appreciation in value every moment: I have a business partner who bought some land 15 years ago and got a value ”notification” once a year, which was enough for him. He could hold his investment and will hold it for 10 more years if needed.
to summarize return:
Looking at the model side by side will look like that:
It may seem confusing for a split moment but think about it: a person who could deal with absolute risk — the possibility to lose the initial capital — should also feel comfortable with a relative return, meaning the option to accept negative return sometimes in the hope to achieve higher returns for the long run. I feel more comfortable with this model vs. the high-risk high return one that in some cases, for some of the best investors in the world doesn’t make any sense. and this logic applies to the risk relative persona- they could not tolerate losing their initial capital so they should choose absolute return even if it is lower over time.
The worst thing to do is to know you are a risk-relativist and get into a relative-return investment. Of course, it depends on where are you on the scale. If you are right in the middle, you could choose and diverse.
The most important advice I have for you, and I will quote Socrates and other smart old Greek thinkers: Know your Self!
*It’s important to say that there is a huge disagreement about Risk and I am not stating that the models above are better or indisputable, it is just how I think about it