The world of investments can be a daunting place. There is the fear that something will go wrong, or that someone is trying to rip you off, and of course there is so much we do not know. On the other hand, without risk, there is no return and accordingly, we have to live with some of the realities (or unpleasantries) of navigating our monies across a sea of complexity. So, to help us along this journey, it is good to bear in mind a few basic paradigms:
1. To make more returns, you have to take more risk. It is the first rule of finance, and if it weren’t so, the whole universe would implode. You have to get rewarded for taking successive risks, otherwise no one would do it. And the notion of risk-free returns or the proverbial “free lunch”, should be quickly dismissed.
2. There is always tail risk and there is nothing you can do about it. Because tail risk (by definition) can occur anytime, anywhere and anyhow, it is somewhat difficult to hedge. And if you buy insurance on everything, your premiums will surely be greater over time than the actual event happening at random.
3. The prediction game is nonsense. Any chart, macro-economic analysis or super computer has been proven to add very little value when it comes to taking views on the future. That is because predicting the unpredictable is rather difficult in a world that is random. Or did you really think that your financial advisor has been blessed by a greater power and figured out the holy grail?
4. Given paradigms 1, 2 and 3, the logical deduction is to diversify. And this is the one universal strategic truth we can all agree on: do not put all your eggs in one basket. However, you have to make sure the baskets are really different from one another and that you are not putting too many of your eggs in one versus the other.
5. Costs and fees matter. If there is one thing that we have complete control over, it is how much we are paying for the risks we are taking. Fees compound over time – reducing them is a tangible value that is easy to obtain (because it is not random) and the purest joy of all (as they never come back).
6. There are no geniuses. The financial services industry has been extremely good at selling itself. However, with an investment universe that is so complex (e.g. random) and a product proliferation that is so great (think stocks, bonds, warrants, futures, forwards, CFDs, and so forth), it really should come as no great surprise that we are all utterly confused. But that’s just it, don’t expect anyone else to know everything either.
The solution, given all these points, and the only way anyone should really manage their investments: Diversify according to risk (not asset class), put a little bit into everything (1/n is always good) and keep your fees low (by not paying anyone to take a view). The rest kind of takes care of itself (see paradigm 1).