Comparing investments is harder than shopping for cars.
Like cars, investments have features, options and the basic parts. A bond has a promise of a regular payment and a promise of return of capital at some distant date. That is the basic part. Like with a car, you might want to understand how good the promise is. Some promises are essentially valueless whereas others, like most government bonds, are near certain. You cannot compare interest rates without understanding the value of the promise. Like the extent, duration and likelihood of having the car company honor the warranty affects price.
Options are a little harder. Sometimes bonds are redeemable at the option of the issuer. That option seldom works in favour of the bond holder and its existence should command a higher interest rate to offset its cost. Some bonds are convertible. The owner has the option to turn them into some other security, usually stock. They usually pay a little less interest.
Stock investments are harder to assess because the variables are more subtle. Understanding the creditworthiness of a borrower is easier than understanding the viability of management and the company’s ability to compete in their industry. Innovation, customer loyalty, regulatory issues and potential lawsuits and warranty claims all factor in.
An investment involves a two-sided assessment. What am I getting for my money and how sure am I that I will get it? As the simple look above showed, that is not easy. The other side is important, too.
What must I invest to get the expected returns?
Money is obvious, but that is just one of many parts of the value committed question. You must be careful to receive payment for each element invested.
If I buy a 5-year term deposit that cannot be cashed before maturity, I have given up both money, risk of loss, and liquidity. If I buy 30-day deposits and roll them over, I will be paid much less interest over 5 years, because the risk of loss and my willingness to give up the money for 60 times longer has value and I am paid for that.
Sometimes I must add time, skill and effort to the investment. Like with a small rental property. I must make much more than a term deposit because I will be fielding repair issues, vacancies, tenant complaints, regulatory matters, significant costs of disposal and other risks. Making three times the rate of return is likely too little.
A small business would require even more inputs.
A drug dealer must make an enormous rate of return because the value of the risk of theft, sudden death, or incarceration can be paid for. It appears that many people undervalue these commitments and as pointed out in “Freakonomics” most street-level drug dealers live with their mother.
In any investment decision be sure you know what you must put into the deal and be sure the deal will pay you for it.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772