How To Evaluate An Investment Opportunity

First off, it should be stated that at least 95% of the time, you’re better off just saying no. Yeah, there are a few legitimate non-mainstream investment opportunities out there, but the chances of you hearing of one of them from your coworker are slim. When in doubt, just say no. Still, if you have plenty of money to lose (and I do mean it should be money you can afford to lose), it might not hurt to at least consider a legitimate pitch. Who knows, you might strike gold and if you don’t, well, it was money you could afford to lose anyway (right?).

Why do they need you?

This is a huge one. Say somebody has figured out a way to earn 50% per year in the stock market with no risk. Why would they tell you? Such a person, if she could afford to invest just $10,000, would be worth over $33 million in 20 years. Why do they need your capital when they could so obviously make more money just keeping their system to themselves and cranking out 50% returns year after year? The answer can’t be “to raise the initial $10,000″ because, well, a person smart enough to come up with such a market-beating strategy should have no trouble earning $10,000 some other way. The only reasonable answer is that they want to “help” poor everyday Joe’s to get rich. And if you believe that, I’ve got some prime swamp land to sell you.

On the other hand, if this is a short-term business loan and your buddy just needs $10,000 in bridge financing to get a new product off the ground and the product has a proven market and you think your friend is a competent businessman, that might be a legitimate investment opportunity. That’s not to say you’ll turn a profit or even get your money back, but at least it’s probably not an outright scam.

The point is, companies only take on investors when they need money for some reason. They wouldn’t give away part of their future earnings unless they believed they were able to earn even more money than what external investors would demand. If you can’t find an obvious need, it’s probably a scam.

What does the person pitching you the investment stand to gain?

Beware conflicts of interest. If a person is pitching you an investment, he or she probably stands to gain something. Try to figure out what it is. Do they receive a commission? If so, you most likely aren’t going to get unbiased advice. Remember, a salesman’s job is to get you to give them money. They aren’t your friend and they probably don’t have your best interests in mind. If they don’t gain anything as obvious as a commission, dig deeper. Is it a multi-level marketing situation? Are you purchasing a product from them in the hopes that it will help you make money (such as a stock trading or forex trading course)? If so, are you able to find any honest feedback about the product on the internet? If you can’t think of any obvious benefit to the pitchman, it’s probably scam. People don’t pitch investments for karma.

What’s the risk?

This is a very, very tough question. And you know what? If you aren’t equipped to intelligently evaluate the risk of a potential investment, you shouldn’t be investing in it. Period. And if you are so equipped, you probably don’t need my advice to begin with. If you don’t even know where to start, skip it. Just don’t take anybody’s word for it that it’s a “low risk” investment! If you can’t independently come to this conclusion on your own, don’t invest.

Is it easy to understand?

There’s an old saying in business that you should never invest in what you don’t understand, and truer words have never been spoken. Most business and investment opportunities are actually pretty straightforward. Are there profitable complex investment schemes out there? Of course there are. But those investments are best left to the professionals who are better equipped to navigate their ins and outs. No matter how enticing, it is never wise to invest in something you don’t fully understand.

Can you follow the price in a newspaper (or the internet)?

Liquidity is a very desirable thing in the investment universe. Yes, the prices of legitimate investments such as real estate and private businesses aren’t quoted in real time on the internet, but most mainstream investments are (including commodities, gold, stocks, bonds, currencies, and derivatives). If an investment opportunity being pitched for you can’t be easily followed on a daily basis, that should throw up a red flag. That isn’t to say that fraud can’t happen with publicly-traded securities, but it is far, far less prevalent. Small, illiquid, thinly-traded markets are much easier to manipulate. Buyer beware.

Does it sound too good to be true?

Pretty much every crappy investment opportunity is easily recognizable as being too good to be true after the fact. The trick is realizing this upfront. I’ll help: nobody can predict the stock market, real estate prices, or pretty much anything else having to do with the economy. Anybody who says they can is probably selling you something. Keep that in mind and you’ll probably be fine.

Further reading:

Guide to Identifying and Avoiding Securities Fraud on the SEC website

Avoiding Investment Scams on the FINRA website

Let me be frank: it really doesn’t make much of a difference in the long term if you hold 35% of your portfolio in bonds instead of 32% or 37% or even 40%. Since nobody can predict the future, nobody can know in advance which exact stock/bond mix will prove optimal. Sure, we can draw a few broad generalizations about the fact that holding 60% in bonds will be significantly less risky than holding 20% in bonds, but once you get down to the 34% versus 38% range the differences aren’t nearly so noticeable. It truly doesn’t matter what you choose at that level of granularity, at least not statistically.

Confidence Drives Behavior

So if  optimizing your stock/bond allocation down the the nearest tenth of a percent doesn’t matter, what does? That’s easy: confidence. Confidence in your plan; confidence that you’ve made the right decision; confidence in the fact that you have considered your specific situation and haven’t just invested in a cookie cutter portfolio using generic advice. Mind you, it doesn’t really matter whether the generic advice is actually appropriate or not. The very fact that it is generic will cause many investors to inherently distrust it. And that’s okay. We all like to think our situation is special in some way.

So How Does One Decide On Their Stock/Bond Split?

It’s really not complicated. We’ll start with the old conservative age in bonds rule-of-thumb and then increase or decrease our stock allocation depending on how you answer a few questions about your specific situation. Will the results of this exercise be superior to blindly following one of the aforementioned rules of thumb? Not necessarily. But the fact that you’ve thought about it in a methodical way will at least give you a better understanding of the issues involved and the confidence to implement your plan.

Start with age in bonds. For example, if you are 35 years old you will start with a 35% bond allocation and adjust your allocation according to how you answer the following questions.

Will you have a significant inflation-adjusted pension other than social security in retirement?
If so, your need to take risk has diminished. Decrease your equity allocation by 5%.

Is your portfolio already large compared to what you think you’ll need in retirement?
Again, your need to take risk has diminished. Decrease equity allocation by 5%.

Do you plan to leave a large inheritance to heirs or charity?
If so, you should invest a bit more aggressively. Increase your equity allocation by 5%

Would you describe yourself as a “risk tolerant” investor?
Increase your equity allocation by 5%.

If you owned equities in 2008, how did you react by the market crash?
If you felt comfortable owning equities even while their value depreciated significantly, add 5% to your equity allocation. If you either sold in a panic, thought strongly about selling, or otherwise experienced extreme discomfort it’s a good bet you were investing beyond your risk tolerance. Decrease your equity allocation by 10%.

Do you save more than 25% of your gross pre-tax income?
If so, you stand a very good chance of meeting your goals without taking on quite as much risk. Decrease your equity allocation by 5%.

Do you work in a stable career with little chance of being laid off or otherwise losing your income?
Increase your equity allocation by 5%.

Does longevity run in your family?
If so, there’s a chance your money will have to last a bit longer in retirement. Increase your equity allocation by 5%.

Tally Your Results

Tally your results. What do they reveal about your risk tolerance and need to take risk? Using the above process, your portfolio could range anywhere between age in bonds – 25 or age in bonds + 25. For example, an aggressive 35 year old investor might have as little as 10% of their portfolio in bonds. Likewise, an extremely conservative 35 year old investor might have as much as 60% of their portfolio in bonds. The average investor will likely fall somewhere in the 30-35% range. I would like to add one caveat: regardless of your results on this test, I recommend you never dip below 10% of your portfolio in bonds nor below 10% of your portfolio in stocks. I don’t believe any portfolio should be 100% in anything.

Where do you stand?

Unfortunately, those three or four magical mutually uncorrelated  asset classes simply don’t exist. You see, asset class correlations shift over time. Sometimes (usually), short-term bonds are an excellent diversifier of domestic equities. Other times, they’re not. Ditto for TIPS. Ditto for commodities. Ditto for real estate. Ditto even for gold. Unfortunately, we are in an age of increasing correlations. According to Morningstar, 9 out of 11 broad asset class indexes they track have become increasingly correlated with the S&P 500 over the past decade, including foreign stocks, gold, REITs, and commodities. The two indexes that actually became less correlated with the S&P 500 are those tracking the aggregate US bond market and the 7-10 year treasury bond market.

REITs Have Become Almost 100% Correlated With The S&P 500

According to Morningstar, the Trailing 12 Month (TTM) average daily correlation of the Dow Jones US Real Estate Total Return USD index stood at 0.59 at the beginning of 2002. A 0.59 correlation coefficient represents a moderate but not spectacular diversification opportunity. Still, even a moderate diversification benefit is well worth chasing after. Unfortunately, at the beginning of 2012 the TTM average daily correlation of that same index stood at 0.91, yielding pretty much no diversification benefit over the prior year.

Should we be concerned that REITs no longer seem to be adequate diversifiers? In a word, no. At least not yet. Remember that “correlations drift over time” statement I made above? It’s not just a theory. It really happens. A lot. I fully intend to remain invested in Real Estate Investment Trusts going forward and recommend you do as well. There are a few obvious reasons why the broader stock market and REITs have become so correlated over the past few years and a few compelling reasons to believe they won’t stay that way, for the most part.

Why Have Correlations Increased?

The S&P 500 now includes several large REITs - The S&P decided to finally allow REITs into the index back in 2001. According to REIT.com, there was only a single REIT in the S&P 500 at the beginning of 2002, Equity Residential (EQR), and that had only been a part of the index since November of 2001. As of now, there are 15 REITs in the S&P 500 with almost 2% of the index being made up of real estate related companies. To be sure, 2% isn’t a large number, but it does make sense that the S&P 500 would become slightly more correlated with REITs over the past decade as they have increased from 0% to 2% of the index. It may be that REITs will go on to comprise even more of the S&P 500 in the future as more private real estate holdings (the vast majority of domestic real estate is still privately owned) are “REITized.” Before 2001, flows off assets into REITs and REIT funds were determined more by fundamentals than anything else. Since their inclusion in the S&P 500, however, flows become much more tied to the broader market. Unfortunately, this isn’t going to change.

“Correlation moves to 1 in a crisis” - There is a lot of truth to this statement. When the fit hits the shan, risky asset classes tend to all drop together as investors flock to the safety of short-term treasuries and gold. Then, as the economy begins to recover, that money tends to pour back into risky assets and they all more or less rise together in a “rising tide lifts all ships” kinda way. Therefore, I don’t think it should really come as a surprise to anybody that correlations are up across the board over the last 3 years. The economy has been through a lot!

REITS have become more accepted by conventional wisdom - Ten or fifteen years ago, not many experts would have recommended a large REIT allocation for most investors. These days, they are recommended by almost everybody. I don’t have any numbers to back this up, but just based on the “prevailing wisdom” I would be very surprised if the percentage of the average portfolio dedicated to REITs hasn’t increased significantly over the last decade. More and more people are buying REITs as a matter of course; they are no longer exotic investments of just a few sophisticated investors. I think this trend is likely to continue.

Why Will Correlations Probably Decrease Again?

But all is not lost! While in-depth analysis seems to suggest it is likely (but not guaranteed) that REITs will be at least slightly more correlated to the broader market in the future than in the past, there are reasons to believe the recent run of very high levels of correlation is temporary.

Separation tends to occur following a crisis - As mentioned above, correlation moves to one in a crisis. The upshot of this is that correlation has usually, in the past, moved away from one after the recovery. Indeed, since the middle of January daily correlations of REITs and the broader market have dropped to below 0.60. Of course, you can’t really conclude anything based on just 30 days of data, but hopefully this is a step in the right direction.

Owning real estate is a distinct business - Owning and operating commercial real estate is just a different business than companies in most other industries are engaged in. Rents tend to be relatively stable, at least compared to the earnings of companies in most other industries. It’s true that lower corporate profits could lead to decreased demand for commercial real estate, but the long-term nature of most lease contracts gives REITs at least somewhat of a buffer. Additionally, real estate can often be re-purposed to fit with shifting demand. Old industrial properties are being turned into residential lofts in urban areas across the country, for example. None of this is to say that the commercial real estate market is immune from economic troubles; obviously it’s not, it’s just that those troubles tend to come in slightly different cycles than the broader economy. I don’t foresee this changing anytime soon.

REITs are extremely exposed to hiccups in the financial market – This is an understatement. Since REITs are required by law to pay out at least 90% of their net income as dividends to shareholders, they depend heavily on the capital markets for expansion. The financial panic really threw most real estate companies for a loop as infusions of outside capital became nearly impossible to come by. Fortunately, the financial crisis was a once-in-a-lifetime occurrence. Will it happen again? Absolutely! But it won’t happen regularly. It could be decades before a comparable crisis hits again. Or at least, I hope so.

We’ve been here before - This is not the first time we’ve seen correlations over 0.90. It’s happened several times in the past, in fact. Correlations moved downward then and there’s no reason to think this time is any different.

Sudden Inflation Wreaks Havoc On A Traditional Portfolio

A sharp increase in inflation is bad for almost every asset class in the short term with two notable exceptions, TIPS and commodities. We’ll get to those in a second. First, we’ll examine the two traditional portfolio asset classes to see why they hold up poorly during inflationary periods.

Stocks - While it’s true that stocks are a pretty decent long-term inflation hedge due to the fact that companies will eventually be able to pass along production cost increase to consumers, they actually make relatively poor short- and intermediate-term inflation hedges. This is somewhat contrary to popular wisdom, but here’s why. When the cost of raw materials shoot up, companies have two options: they can either raise their own prices or take a hit to their own profit margins. Companies with strong economic moats such as Coca-Cola and Apple can afford to raise their prices – you don’t think kids are going to go without sugary beverages and hipsters without their Apple products, do you? – but the majority of companies can’t get away with passing along their increased costs right away. So their earnings suffer, at least in the short term. And when earnings suffer, stock prices drop.

Bonds - That bonds are vulnerable to inflation is fairly obvious. Simply put, nominal bonds pay a fixed rate of interest until maturity regardless of what happens with inflation. The longer until maturity, the more exposure a bond has to inflation risk. A 5% interest rate looks decent when inflation is 2% but it isn’t nearly as nice when inflation doubles to 4%. Short-term bonds aren’t as vulnerable because you don’t have to wait as long to reinvest the principal at a higher interest rate.

Investments That Hold Up Well To Inflation

Here are three alternative asset classes that hold up relatively well to sudden spikes in inflation.

Commodities – Raw material, crops, oil. The price of the stuff that fuels our economy is intimately linked with the consumer price level. It’s no surprise that commodities are positively correlated to inflation, even unexpected inflation. Unfortunately, there really aren’t any good low cost commodity mutual funds out there. Among open-ended funds, Pimco Commodity Real Return (PCRDX) is probably your best bet.

TIPS – Treasury Inflation Protected Securities are probably my favorite alternative asset class. TIPS are extremely well-correlated with inflation, which is kinda the point. Like regular bonds, TIPS pay a particular interest rate until maturity. Unlike regular bonds, the principal is adjusted twice annually in response to changes in the consumer price index. If inflation goes up, so does the principal. In the event of deflation, however, the principal goes down. Thus, the interest rate paid on an inflation protected security is in effect its guaranteed real rate of return. That’s a deal you really can’t get anywhere else. Of course, TIPS are only as good as the credit of the U.S. Treasury but I don’t think there’s any danger of a default anytime soon, despite the recent hysteria.

Gold – Yes, gold is an excellent inflation hedge and yes, it may have a small part to play in a diversified portfolio. Not that I’m a gold bug, or anything. I still think gold has too many negative characteristics to make a good long-term investment on its own. But as ballast to a broadly diversified portfolio, I think it can have its uses, particularly when unexpected inflation strikes.

Investments That Are Moderate Inflation Hedges

Here are two more investments that, while not perfect hedges against inflation, can do a decent job of hedging against moderate price spikes.

Real Estate – This could refer to both direct investment in real estate or REITS, although I prefer REITS. The reason I list real estate as only a partial inflation hedge is that prices are determined as much by rent levels as by land and material prices, and rents are determined as much by local supply and demand as anything else. It’s quite possible for rents, and thus prices, to fall even when inflation heats up. Of course, this can’t continue forever. Eventually rents will return to equilibrium with the overall price level.

Cash – Since cash investments are essentially very, very short-term bonds, they have very little inflation risk. Since cash securities mature so quickly, they can always be reinvested at higher rates. Still, this only goes so far. There reaches a point when financial institutions are no longer willing to pay ever higher interest rates on short-term cash deposits, regardless of what inflation is doing.

So it is.

A Breakthrough Study!

In a new study (opens as a pdf), Vanguard definitively answers the question we already knew the answer to: yes, sometimes if you are really, really good and lucky you can beat the market! Okay, that’s not exactly what the study says and it contains a few worthwhile insights. Let’s break it down.

Core And Explore Explained

Vanguard’s point revolves around the old core-and-explore theory of portfolio management. Traditionally, this has meant you should index within asset classes characterized by a very efficient market (large-cap U.S. and developed market stocks, for instance) and opt for active management in “less efficient” market segments (such as emerging markets, micro caps, etc).

Vanguard’s Take On Core And Explore

Vanguard turns this logic on its head, noting the data shows that indexing works very well in all market segments regardless of their reputed “efficiency.” Since the data clearly supports the notion that indexing is just as effective in, say, emerging markets as in the domestic market, indiscriminately opting for active management in for the developing market portion of your portfolio is unlikely to pay off. Rather, Vanguard’s approach is to focus on identifying talented and low-cost managers regardless of the part of the market they work in. That is, a talented manager in the large-cap U.S. stock space probably has a better chance of beating his benchmark than a below-average manager in the emerging market small-cap segment.

Making extensive use of back-testing, Vanguard’s findings lead some credence to their theory. Academics have long known that active managers do, on average, provide value through their stock-picking services. The kicker is that they don’t provide enough value to overcome the prices they charge! Put another way, the average stock-picker does seem to exhibit some small amount of skill. Unfortunately, the rewards will go directly into the skilled manager’s pocket and not to investors. This actually makes a lot of sense when you think about it. In an efficient market, the rewards of any endeavor are likely to go to the person who possesses this rare and special skill (talented stock picker) rather than to those who lack any special skills (mutual fund investors). Finding stock pickers who are both talented and who fail to charge a fee commensurate with their abilities is extremely difficult. Still, they do exist according to the research published by Vanguard.

But How Do You Find Skilled Managers?

Vanguard does give us a hint-a very important hint, in fact. If you want to increase your odds of beating the market, you’re more likely to find skilled stock pickers amongst the lowest-cost managers on the market and not the highest. This follows intuitively if you realize, as we do above, that stock pickers on average do out-perform the market slightly before accounting to fees. Since management skill is so difficult to come by, if your goal is to beat the market it makes much more sense to cut expenses rather than push for yet more skilled managers (which may not even exist!).

So far so good. We know that, all else being equal, we should look for skill amongst low-cost managers. But that’s not really enough information to consistently pick a winning mutual fund. Low costs will certainly increase your odds, but will they be enough to tip the scales in your favor? Probably not, especially not if the manager is “cheap for a reason,” so to speak. You’ve got to find a way to determine which of the cheap managers is undervalued and which are just bad. Unfortunately, Vanguard doesn’t provide us with any guidance here, making the study in-actionable mostly worthless. I suppose you could use past performance to try to identify which managers are likely to out-perform going forward, but a veritable mountain of evidence convinces us that’s a losing strategy.

So what’s the deal, Vanguard? Are you going to give us the recipe for your secret sauce or not? I’ll pay good money for it. Until then, I’ll continue to stick with index funds.

How Do Bonds Work?

A bond is a contractual obligation for a company or government entity to repay the principal of a loan at a pre-determined future date along with regular interest payments at specified intervals. There are plenty of bonds with unique features that make this a somewhat oversimplified explanation, but essentially what happens when you buy a bond is that you become a lender in the same way the bank who underwrote your mortgage was a lender to you. When you borrow money to buy a home, you know what your monthly payment will be (or at least the formula used to calculate it if you took out an Adjustable Rate Mortgage) and how long you’ll have to pay it. So it is with corporate and government bonds.

Bond Interest Rates Versus Risk

Most bonds pay interest twice per year, although there is some variation, and the length of time a bond will pay interest until the principal is repaid is called the bond’s maturity. In general, longer-term bonds will tend to pay a higher interest rate than shorter-term bonds and lower-quality bonds will tend to pay a higher interest rate than higher-quality bonds. This is because longer-term bonds have more credit and inflation risk than short-term bonds. That is, you’re more likely to run into problems the longer you lend out your money because while it’s relatively easy to predict what might happen a year or two from now, it’s much more difficult to predict what might happen 20 years down the road. Thus, long-term borrowers have to pay a risk premium to convince investors to part with their money for such a long period of time.

Similarly, the credit quality of the borrower plays a big role in determining a bond’s interest rate. Treasury bond rates tend to be lower than corporate bond rates because they are considered to be less risky. Junk bond rates, naturally, have to be much higher in order to tempt investors. The flip-side, of course, is that there is a much higher risk of default (meaning you don’t your money back at all) the lower you go on the credit quality ladder. For this reason, most experts highly discourage owning anything other than treasury and high-grade corporate bonds. Municipal bond rates are a special case. They usually pay lower rates than other bonds with similar characteristics because their interest payments are exempt from federal income tax.

Note: I highly recommend you familiarizing yourself with the Morningstar Bond Style Box.

Bond Interest Rates Versus Bond Prices

One of the most confusing things to most people is that bond prices move inversely with bond interest rates. When interest rates go up, bond prices fall. When interest rates go down, bond prices rally. Why? Because if I own a bond paying 5% when prevailing interest rates are only 4%, there’s no way I’m going to sell it for what I paid. I’m going to jack up the price so that the effective yield to the buyer is going to be right at the prevailing interest rate of 4%! Similarly, if interest rates go up to 6%, nobody is going to pay face value for my 5% bond. I’m going to have to lower the price if I want to sell it. The measure of how sensitive a bond fund’s price is to fluctuations in interest rates is called its effective duration.

What Do I Recommend For Your Bond Portfolio?

In general, a short- or intermediate-term high-grade bond fund should form the core of your bond portfolio. The best bond funds will own only high-quality bonds, sport low expenses, and have an average duration under 6 years or so. For investors who don’t mind a tad more complexity, I recommend a two-fund fixed income portfolio containing both a TIPS fund and a short- or intermediate-term nominal bond fund.

But never fear! I’ve decided to make things very easy for you. Below I’ve compiled a list of three legitimately-guaranteed investments. If you are being pitched a “guaranteed” investment not on the list below, there is a 99% chance you are being misled. Sure, there are exceptions to every rule and from time to time there probably are guaranteed or near-guaranteed investments other than those on the list below that do pop up. But it bears repeating and I cannot stress this enough, there is a 99% chance you are being misled! I don’t know about you, but I don’t like those odds. And let’s face if, if you are the type of person to be attracted to “guaranteed” investments, chances are you don’t know enough to be able to sort the good opportunities from the bad. In this situation, it’s best to just say no. Yeah, you may occasionally (once in a hundred years) miss out on some huge opportunity, but it’s much more likely the only thing you’ll miss out on is losing your life savings.

The Three Classes Of Legitimate Guaranteed Investments

So is there such a thing as a guaranteed investment? As it turns out, there is. There are three classes of truly guaranteed investments I’m aware of, all of them coming with some sort of explicit government guarantee, which is what makes them so safe. As you may have guessed, these are all low-yielding investments.

1. U.S. Treasury And Savings Bonds – The United States Treasury offers a variety of guaranteed bond products whose repayment of principal is backed by the full faith and credit of the United States Government, making them perhaps the safest investments on earth. These include short-term Treasury Bills, savings bonds, TIPS (Treasury Inflation Protected Securities), etc. While all longer-term Treasury bonds except TIPS do have inflation risk. or the risk that your interest payments won’t be enough to keep up with inflation, at least your principal is guaranteed. Those interested in absolute safety should stick with the lowest-yielding 90-day Treasury bills.
2. Certificates Of Deposit and FDIC-insured Savings Accounts – Following closely behind U.S. Treasury obligations on the risk scale are CD’s, savings accounts, and any other account insured by the FDIC, a branch of the federal government. The short-term risk-free nature of FDIC-insured accounts makes them ideal for short-term savings for purchases you’ll need to make within the next few years. A word about foreign bonds or CD’s: even though some of these investments may be guaranteed by foreign governments in no danger of defaulting on their obligations, these guarantees almost never extend to exchange rate risk. That is, while those UK bonds may be guaranteed to repay your principal in British Pounds, if the dollar loses value against the Pound you will still lose money. Hence, these aren’t guaranteed investments, at least from the perspective of the American investor.
3. Immediate Annuities – While immediate annuities are issued by private insurance companies and not the government, their value is usually explicitly guaranteed by state regulatory bodies up to a certain limit (similar to FDIC insurance). I won’t argue the merits of buying an immediate annuity (for the record, I believe an immediate annuity is appropriate for some modest percentage of your portfolio especially if your family is long-lived) and I won’t delve into the merits of the plethora of insurance riders you can buy in addition to the basic income stream, but I will say that these products are extremely safe so long as you stay under the state limits. Since state finances tend to be a bit shakier than federal finances and there is insurance party risk, perhaps I should stop short of calling these a truly guaranteed investment, but I believe they are close for all practical purposes.

Sadly, no amount of financial wizardry can undo the fundamental relationship between risk and return. Simply put, low-risk investments tend to be low-paying investments while high-risk investments tend to be high-paying investments. Any investment product proposing to violate this fundamental law of finance is most likely a scam! Put another way, you aren’t going to earn high returns with a low-risk investment. You’re just not. Accepting this statement as undeniable fact will go a long way towards helping you avoid being ripped-off. If you train yourself to expect high-return investments to also be high-risk investments, your BS detector will immediately go off anytime some scammer tries to convince you otherwise.

Principles For Avoiding A Scam (Any Scam)

If It Sounds Too Good To Be True…

Seriously, if it sounds to good to be true, it almost certainly is. Many people who fall for scams had this warning bell going off in the back of their minds the entire time but ignored it. Don’t ignore it.

Disbelieve Theories That Sound Logical But Don’t Have Independent Data To Back Them Up

Con artist is short for “confidence artist,” meaning they are skilled at gaining the trust of others. And it’s obviously easier to scam somebody who trust you than somebody who distrusts you. Hence, the best defense against con artists is to avoid any investment or system inherently depending on trust: trust of an investment manager (this rules out most active funds, btw), trust a salesman’s product will do what he says it’s going to do, etc.

But without trust, it’s impossible to accomplish anything. So if you can’t take people at their word, how do you know when something is legit? Simple: independent data. This could take the form of independent reviews of a product or service on the internet, consulting a trusted expert in the field (perhaps your nephew is also a financial advisor), or even an academic study on the topic by some esteemed professor. The point is that you should never take anybody’s advice when they have a direct financial incentive for you to follow that advice. If you ask an insurance salesman if you need more life insurance, he’s probably going to say yes. Similarly, a barber will probably tell you that you need a haircut. If you can’t verify the accuracy of any claim independently of the person making the claim, it’s best to pass. If a con artist can’t get you to trust him, he can’t con you.

Be Skeptical Of ANY Claim Regarding Low-Risk/High-Reward Investment Opportunities

As noted above, a fundamental relationship exists between risk and return. A con artist can no more circumvent these rules than defy gravity. Any claim that a high return can be earned with little risk should be met with intense suspicion for this violates one of the fundamental laws of finance. Do you really think you can earn a 40% return on your money with no risk from some guy

Always Compare Past Performance Claims To A Reasonable Benchmark (Usually Not The S&P 500)

One common trick salesmen use is to compare the performance of their product to an inappropriate benchmark, often the S&P 500 index. Now if the investment in question invests solely in the large-cap blend portion of the style box, the S&P 500 is probably a reasonable benchmark. Otherwise (and this is usually the case), it’s probably not. Who cares if an investment trust owning mostly small-cap emerging market stocks beat the S&P 500 over the past 10 years? That is an apples-to-oranges comparison with the sole intent being to trick you into thinking the investment you’re being pitched is better than it really is. This is a huge red flag because if the investment opportunity were really as good as claimed, they wouldn’t need to resort to misleading statistics in order to sell it.

Ask Yourself: If This Is So Profitable Why Do You Need Me?

This one should be obvious. Have you seen those banner advertisements around the web promising 20% monthly returns (or some other ridiculous number)? Chances are, you have. Now ask yourself this: if these people could really earn 20% per month on their money, why do they need to take on external investors at all? Earning 20% per month, a $1,000 initial investment would yield over $411 BILLION in 10 years! By investing only $1,000 of their own money, these “investors” could become the richest person in the world 10 times over within a mere decade. Tell me, with prospects like that, why do they need your money?

I’ll tell you why, because their system doesn’t work. Their profits come from scamming you!

What is a Stock Trading Simulator?

A stock trading simulator allows you to make paper transactions and follow the performance of the stock based on certain conditions being true. Some programs will allow you to enter different variables and then the computer will project the performance of the stock based on those conditions.

For instance, a change in interest rates can affect the price of a stock. Other external factors such as world politics and monetary policy can affect the stock market. A good stock trading simulator will allow you to get an idea how different changes can influence individual stocks as well as the overall stock market.

Unfortunately, playing with fake money and accumulating big profits is not the same as making real investments with real money. Mock stock trading doesn’t prepare you for the real thing. There are several reasons why your success or failure in a mock stock trading competition does not necessarily translate into the same success or failure in real life.

Assumption of Risk

When you buy and sell stocks in a mock stock market, you tend to take much bigger risks than you would normally do if you were actually buying or selling stocks with your own money. Paper trading or the simulation of real trades becomes more of a game or a study in the way the stock market can either reward you for taking big risks and being right or punish you for taking big risks and being wrong.

It is no different than playing a game like Monopoly. In that game, the idea is to accumulate all the property and wind up bankrupting everyone else. In real life, you would find it very difficult to control the housing market and gain a monopoly. Even Donald Trump would have a hard time playing Monopoly for real.

A Balanced Approach

Most prudent stock investors will create a portfolio that is balanced and diversified. Such an approach reduces overall risk and also reduces the chance for huge gains. In a mock stock market, one can experiment with individual stocks or with unusually high risk and high return stocks. You might get lucky in a new technology or biotech stock and think that you can do it again in real life.

Trying to repeat the same performance with high-risk stocks in real life is usually a losing proposition. For every one winner, there are probably at least 10 losers. You should never risk more than a small portion of your entire stock portfolio on highly speculative stocks.

What Does “Priced In” Mean?

Often times on internet message boards, individuals will be discussing the merits of investing in some stock or another. One poster will outline the factors that make some stock or another a particularly good investment. Perhaps that company has just discovered a new miracle cure or completed testing on the next Apple iPad killer. Inevitably, one of the other participants will dismiss all these positive developments, saying they are already “priced in.” What exactly is mean by that term, anyway?

It’s Expectations That Matter

Contrary to popular belief, stock prices are not set by past events but rather expectations of the future. What’s past is past. While that last blockbuster product may have made past stockholders rich, it’s not going to make that stock’s price go up in the future. Why? Because the effects of that blockbuster product are already well understood and its future impact on earnings relatively easy to predict. If everybody knows company A will earn about $1 billion dollars in profit next year because of that product, the price of the stock will rise to reflect the company’s expected results before those events transpire. By the time those sales are made and earnings actually booked, it will be too late to profit from them.

When somebody says some bit of news is “priced in” to the stock, what they are actually saying is that that specific bit of information is so widely known and anticipated that it will not cause the price of the stock to go up even if (indeed, especially if) the event transpires as expected. In order for the stock price to move up, the result would have to turn out to be even better than expected. Similarly, if it happens that the company’s results are still good but not quite as good as expected, the stock price will likely drop in response.

Example A:

Company A is expected to earn $500 million this quarter.

Thinks go exactly as expected and Company A does, in fact, earn $500 million.

There is no change in the stock price as a result since the result matched the expectation.

Example B:

Company B is expected to earn $500 million this quarter.

Things go even better than expected and Company B ends up earning $550 million.

Company B’s stock rises in value since the result was greater than the expectation.

Example C:

Company C is expected to earn $500 million this quarter.

Things go well, but there were a few hiccups along they way. Company C ends up earning only $490 million this quarter.

Company C’s stock declines in value since the result was less than the expectation. It doesn’t matter at all that $490 is still a very healthy profit. All that matters is that the result fell short of the market’s expectations.

As you can see, making money in the stock market is a lot more difficult than simply figuring out which companies will do well in the near future. Indeed, a company could do very well and its stock could still lose value were the market expecting it to do exceptionally well. It Is this dynamic that makes choosing stocks so difficult. Not only do you have to accurately guess how different companies will perform (a difficult feat, no doubt), you also have to be able to accurately guess how other investors judge how well those companies are likely to perform, which is an infinitely more difficult task. Still think you can pick stocks?