Even now, there's no free lunch

  • Article by: ROSS LEVIN
  • Updated: August 22, 2009 - 5:10 PM

You can't get more without risking more, despite our desperate times.

One of our daughters had her nose out of joint because she claimed that I never wrote about her in these columns.

While it is true that recent musings have included stories about her twin sister, no matter how much we tried to persuade her otherwise, we could not dispossess her of this false accusation. Being a student of behavioral finance, I could clearly see that she was suffering from the "recency effect.''

What has just happened, this theory goes, bears far more importance than what has happened over time. But a parent of a teenager must act differently than a professional adviser, so rather than attempt to prove to her the flaw in her thinking, I have featured her in this introduction.

The mythology of the market matches the family perspectives on my column. I am hearing about fantastic new strategies for somehow making up last year's losses with either less risk or no risk. Desperate times call for desperate measures, so it is no wonder that people are clamoring for something for nothing.

Modern portfolio theory may come under scrutiny for one of its premises: that the price is right. That is, the market always gets the share price correct because information is instantly processed. We have seen in the past year shares of good companies with good prospects get pummelled nonetheless as panicked investors bailed out of all stocks.

But portfolio theory cannot be called into question on another key premise -- that there is no free lunch. Put another way, in order to get higher returns, you must take on higher risk.

Yes, it was briefly true at the end of the first quarter that for the only time this century, 30-year performance of 10-year Treasuries was better than the 30-year return on the Standard & Poor's 500. But that quickly righted itself.

The lessons that need to be learned are the same ones. They are actually pretty simple:

Borrowing increases your risk. If you borrow to buy stocks, own companies that have a ton of debt, or leverage your real estate, you are increasing your risk. Since an increase in risk can also provide higher returns for some period of time, it may seem that a strategy is doing much better than it actually is. Huge mortgages on rapidly appreciating vacation properties were only a problem when the properties quit appreciating. When the asset is no longer worth the debt attached to it, or you are forced to reduce your debt for reasons out of your immediate control, real financial pain ensues.

All asset classes revert to their statistical means. No matter what the investment -- stocks, bonds, gold, timber, tulip bulbs, or baseball cards -- it eventually gets priced too high and sells off. This is so fundamental that it should need no explanation. No matter what the asset class in which you are investing, you want to peel money from the winners and give to the losers.

Uncertainty is not only a fact of life, it is a fact of markets. Markets are very unpredictable over the short term. They are also unpredictable over the long term, but less so. This means that money you are going to spend in the next three years should not be invested in stocks.

Volatility is a huge risk, but so is inflation. You cannot avoid risk, so you have to decide how much of which type of risk you want to accept. The fewer years you have to live, the less you need to worry about inflation. But if you are in your 60s and live with a spouse, protecting your spending power should be a priority.

Lower returns mean more saving, less spending, or both. You own stocks because over a reasonable time frame they have a higher probability (not a guarantee) of being worth more than bonds and thereby increasing your ability to spend in the future.

All things being equal, costs matter. Be sure that you understand why a particular strategy with higher costs is reasonable.

Humility pays. No one has all the answers. Anyone who promises you that they are superman also has an ego that is their kryptonite.

If something seems too good to be true, it is. End of story.

In Justin Fox's outstanding book, "The Myth of the Rational Market, a History of Risk, Reward, and Delusion on Wall Street,'' he says: "We are often of two minds, one that impatiently demands satisfaction now and another that rationally weighs the present and future rewards."

The impatient mind is essential for avoiding danger and provides helpful instinctive guidance. It also falls prey to the folly of investment promises and gimmicks, as well as things like my daughter's focusing only on recent events. But, it is the rational mind that will profit from lessons learned.

Spend your life wisely.

ABOUT THE AUTHOR

Ross Levin is the founding principal of Accredited Investors Inc. in Edina. He is a certified financial planner and author of "The Wealth Management Index." His Gains & Losses column appears on the fourth and fifth Sundays of the month. His e-mail is ross@accredited.com.

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