The Only Thing That Matters When Investing

When I was a ninth grader, I started messing around with an old smoky spanish guitar that my parents had in the basement.  I didn’t even tune it and just invented some songs based on hitting the open strings.  Then I learned chords and a few songs because like Napolean Dynamite said “nunchuck skills, bow hunting skills, computer hacking skills. Girls only want boyfriends who have great skills!”  I got my own guitar and I remember how when I started to learn bar chords, I had an epiphany.  With only one or two chord formations slid up and down on the neck I could play anything!  I mean anything!!!  Within a couple of days I could turn on the radio and play a rough version of whatever came on.  Take the same bar chord and pick the strings individually and it becomes country or folk.  Only play the bass strings together and it turns into a power chord to rock stadiums or get my punk on yo.  It was like a whole new world had opened up for me.  I had the same thing happen to me with respect to money and investing when I had the epiphany that the only thing that finance guys care about in investing is risk adjusted returns.  Everything else is just noise unless it affects return or risk. all of the things that had previously seemed disparate suddenly were revealed as linked in an obvious way.  I was preparing to buy my first rental property and learning about real estate cap rates.  At the same time, I was looking more at my brokerage account since the balance was starting to become interesting and I was thinking about stocks and P/E ratios.  At work, we used NPVs to evaluate which projects to fund, and because I knew that I wanted to start a business some day, I also knew about valuations based on business income multiples.  But I viewed these all as different and separate ways of making money.  The epiphany in thinking about how these things are linked looks like this:

Investment Returns

If a rental property has a cap rate of 10% you can expect a 10% return every year

If a no dividend stock had a P/E ratio of 10 that never changed, you might expect a 10% return every year

If a project has a guaranteed NPV of $100K on a $1M investment over one year that is a 10% return

If a business nets $100K per year but the business costs $1M, then it has a 10% return.

Investment Risk

But return is not always guaranteed because there is risk right?  Thinking about risk let’s go back through the same list above only instead of hypothetical returns let’s look at the actual rates of return from a specific point in time, when I wrote this post (as these rates are always changing based on market conditions).

Bonds issued by the government or by companies may yield 3-4% but have relatively little variance or volatility. 

The average return of stock in those same companies that issue bonds over the last 50 years was around 7-8%, however, there is huge volatility in this over time and a huge variance in individual stocks. 

Rental properties are somewhat stable investments and a good cap rate may be 10-12% but this takes some hands on effort.

If a business is funding a project with a 5+ year commitment, the NPV is generally 2-10X the investment and has an annual return on investment of 20-100% or more but the failure rates of these ventures may approach 70% or more.

More standard brick and mortar type businesses may actually sell at a multiple of 5-8X income with an annual return of over 20% but revenues are never guaranteed and one needs to actively run this business.  

With web based businesses or service businesses the multiple paid may drop down to around 2X with an annual return pushing 50% or more but there are few assets and the income depends so much on the operator that it is almost like buying a higher paying job that you are now financially tied to.

If You Understand Risk Adjusted Returns, You Understand Business

The picture that I am trying to paint above is that as you move up in amount of risk and work required, the return moves up.  Hence the 2nd half of this epiphany was risk.  The realization that I had as a younger investor was that returns vary by asset type but in a perfectly efficient market, the risk adjusted return of all of these possible investments should be identical.  Moreover, since in reality it is not identical, this is the only thing that matters as an investor.  Really investing is not about stocks and no different than business, it is about getting the best possible return for your cash regardless of where you put that cash.  I could make 3% in government bonds with almost no risk, I could make 7-8% in stocks with some more risk, I could make a bit more like 10-12% in real estate but then I would have to landlord it carrying some amount of burden, or I could make 20% or much more being active in a business but that carries even more stress and potentially more risk.  It is almost like everyone else has to make the same decisions with where to invest money and that is what drives the market and rates of return (sarcasm).  The epiphany of my younger self was that this is exactly how it is.  This changed the way that I saw investing in that now I try to stay in the loop on return rates across all asset classes that I am interested in and look for market inefficiencies where the return is higher than the risk suggests it should be.  It also changed the way that I viewed our board at my company in approving or denying my projects.  They didn’t care about how totally awesome my project was for the world or how it could create a whole new platform, all they cared about was risk adjusted return and risk profile versus the rest of the portfolio that they were considering.  And lastly, it changed the way that I saw business as interrelated.  If a bank pays me 1% interest on my checking account and then they have overhead then that is why a mortgage from that bank costs a 4.5% interest rate.  Take it a step further that the bank is a public company and in order to please it’s owners (the stock holders) they need to net an average of 8% return or else get out of banking and into something else more profitable.  That’s why the bank provides other revenue generating services and why those services cost what they do.  It is also why the bank doesn’t hold those mortgage loans but often packages a bunch of them together into a security that yields 3% and then sells that security to other holders who like that risk profile in order to make their targeted returns and asset risk profile to make their investors happy and to remain solvent.  You get the idea, just like moving chords around on a fretboard by sliding, I can slide between asset classes, I can explain why business decisions are made, I can see how changes in one asset class might affect another, and to some extent I can extrapolate macroeconomics of business.  If you understand this deeply, it’s like you could play anything!