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There's no such thing as a low risk high reward investment

There's no such thing as a low risk high reward investment

Low risk high reward investments… are not a thing

Everyone wants a low risk, high reward investment. I have to admit, it sounds pretty sexy to reel in massive profits with little to no risk of loss! Unfortunately, there’s no such thing in the public markets. At the end of the day, people will always bid up the price of a sure thing. But, there are ways that I can increase my chances of making a profitable investment, and decrease the risk at the same time. It’s not low risk, high reward, but it’s definitely close!

There’s no shortage of ways to make lots of money investing

Don’t get me wrong! There’s a ton of potential investments with high reward. If you’ve come to this page looking for investments that might yield incredible gains, then please allow me to list off my own personal short list of high reward investments. These are all very high risk, which I will dig into more in a moment.

  • Options

  • Tech stocks

  • Emerging markets stocks or bonds

  • Frontier markets stocks or bonds

  • High yield bonds (aka junk bonds)

  • Distressed debt or bonds

  • Leveraged real estate investments

  • Credit default swaps

  • Interest rate swaps

  • Currency and forex

  • Basically ANYTHING if you borrow to buy it

However, trying to find an investment that is both high reward and low risk is nearly impossible.

Why high reward investments always come with high risk

What would you say if I told you that I had a stock that you could buy that had paid a 50% dividend for the past 80 years. In other words, if you bought it, within two years you would have already paid off your initial investment. And, you know that it’s been paying out that way for longer than your grandparents have been alive, so there’s little to no risk of it going under.

Hopefully, you’d throw every single dime you ever made into that stock! And then borrow every cent you could to buy even more! To be honest, you would be absolutely crazy not to. If you don’t want to buy, I can guarantee there will be millions of people who will, which will drive the price up quickly.

That is why there aren’t any low risk high reward stocks. Anything that’s a “sure thing” will get bought up to the point that it yields less and less and less, either in potential future appreciation or in actual income (if we are talking about bonds or fixed income or dividend stocks). It’s a relatively simple principle, but most fundamental truths are.

Two exceptions to the rule: non-public or low-opacity investments

Having said all of that, there are a couple of exceptions to the rule: non-public or low-opacity investments. If a company or investment isn’t publicly traded then it is more difficult to buy and sell, potentially limiting the pool of buyers and providing a pricing advantage.

To illustrate this concept, I’ll give you an example. Let’s say that I own an excavation company in Barrow, Alaska. If you don’t know where Barrow is, that’s because nobody does. It’s in the middle of nowhere, and it’s almost impossible to get to. Let’s say just for kicks that this company brings in $1m in revenue every year and yields about $300,000 in income after all expenses. If it were someplace accessible, in a big market like Sacramento, or Chicago, I could probably sell a similar business for $600k-$1.5m because there would be a huge pool of competitors, buyers, and investors who know the market and feel comfortable buying a business in that area.

But in Barrow, Alaska? There probably isn’t a single person who would know how to run the business and would be comfortable buying it. There’s little to no knowledge pool about excavating in Barrow, Alaska, so there’s no way to make an intelligent investment there. Because of this, I might only get $300k-$500k for the business, and it would probably take a long time to find someone willing to buy it.

It’s still possible to decrease risk and increase potential reward

Although there is no such thing as a high reward low risk investment on the public market, that doesn’t mean that I can’t decrease the risk of my investments and increase the potential reward. It won’t come as any surprise to those of you who read the blog what the methods are that I use to do this:

  1. Diversification

  2. Knowing where the market cycle is

  3. Investing in what I know

Diversify to decrease risk and increase exposure to potential reward

I diversify for two very simple reasons. It exposes me to lots of potential investments and therefore lots of potential investment gains. Conversely, it also limits the potential impact of a loss on any single one of those investments.

If you don’t know where to get started with diversification, then I would recommend signing up for a free account with Personal Capital. They have an automated tool that allows you to select the amount of risk you are comfortable with, and then will automatically suggest a backtested allocation that will match your needs and comfort level.

Below you can see the sliding scale that allows you to input your risk tolerance.

Then, it spits out a suggested allocation, along with the difference between your current allocation (if you have any) and this suggested allocation.

Knowing where I am in the market cycle

This might seem incredibly obvious, but the other way that I decrease my risk is by buying investments at the right time. It’s almost impossible to “time the market”, but I like to be aware of whether a particular investment is at or near a historical high point or low point.

For instance, although there has been some increased volatility lately, the stock market is generally near all time highs. Same for the real estate market.

Even though both markets are high appreciated at the moment, I have confidence that over the long term they will continue to appreciate, and I really have no idea when and how they will do so. So, I am still investing but I am doing so at a measured pace, over time, with a fixed investment amount every 3-4 months. This is called dollar cost averaging, and it ensures that I will spread the timing risk of my investments out over a longer period. It’s like diversification, but with time.

Go with what I know

My last rule is a very simple one: I invest in what I know. Since I don’t know anything about excavating in Barrow, Alaska, I am not going to buy an excavating company there. Same thing with FOREX and interest rate swaps and many, many other things.

I go with what I understand, and that allows me to feel more confident in my investment decisions.

It’s all about improving my odds because there aren’t any low risk high reward stocks

There’s no magic to investing, no silver bullet. The only way for me to be successful over the long run is to stick with what I am comfortable with, diversify, try to buy at relative lows and sell at relative highs. Simple. But not easy.

 

70 posts down, 700 to go: Thank you for reading!

70 posts down, 700 to go: Thank you for reading!

Lost and Founder: A book every startup employee should read

Lost and Founder: A book every startup employee should read