I have written about the importance of considering both investment risk and returns when assessing the viability of an investment. In fact, the world’s best investors tend to have a very low tolerance for risk – they only invest in ‘sure things’.
In my experience, novice investors can talk themselves into believing that an investment exhibits less risk than what it actually does. The solution is to understand what evidenced-based investing is and how to use it effectively.
There are three ways to make money
There are three ways to make money being investing, speculation and business. Let me explain the difference:
- Investing: the goal with pure investing is to turn the risk/reward equation on its head and generate the highest possible return for taking the lowest possible risk. Of course, there is always some level of risk. However, with pure investing your views in respect to the expected investment returns from said investment should be supported by an overwhelming amount of evidence.
- Speculation: there is very little evidence to support your investment views. There is rarely a proven track record of results. There is a lot of uncertainty. Speculation is tantamount to gambling.
- Business: involves the generation of profit and/or value through the application of capital, intellectual property and/or personal exertion. This is often not regarded as ‘passive’ wealth accumulation as operating a business involves (a lot of) work/effort. If it is passive, then its more akin to investment than business.
Sometimes one looks like the other
As the diagram below (click to enlarge) suggests, sometimes these three categories overlap, and it becomes unclear what an investor is doing.
For example, a small-scale property development is closer to a business than it is an investment. Furthermore, trying to identify the next growth suburb/corridor and investing in that location is closer to speculation than it is pure investment.
The question is; will you be rewarded for the risk?
It is very important to conduct an honest, emotionless appraisal of where your current investment activities fit in the above diagram. Avoid the temptation of talking yourself into concluding that you are investing when you are really speculating. The best case is that you are operating in the top of the yellow circle i.e. pure-investment.
The key differential is evidence
The main difference between pure investing and speculation (and even business to some extent) is the volume of evidence that exists which supports whether the investment will perform as expected. If the evidence isn’t overwhelming, then you are probably speculating.
Let me give you an example. Compare two different properties (both sold in the last couple of weeks):
- 4001/151 City Road, Southbank is a newish 3-bedroom apartment that sold for approximately $950,000. It first sold in 2013 for approximately $890,000. That equates to a growth rate of only 1.4% p.a. over a 3-year period – which is a very short history for any investment.
- 25 Tyrone Street, South Yarra is a 3-bedroom house that sold for just under $1.6 million. It sold in 1975 for $37,000. No doubt it has been maintained and renovated over that time but nothing substantial (floor-plan remains unchanged). That equates to a growth rate of 9.2% p.a. over a 42-year period. Substantial and compelling evidence.
Putting aside that the fundamentals of these two properties are vastly different (new-build versus older-style property), let’s just focus on what the evidence is telling us. One has very little evidence of growth (essentially none) and the other has four decades of strong evidence.
I picked a property example because they are easy to relate to. I also could have compared two investment strategies; picking a few direct stocks to invest in versus investing in an index fund to make my point. Studies have shown that ‘stock picking’ is almost always unsuccessful whereas index investing is proven to produce superior returns (compared to the alternatives) over the long run. The evidence is compelling.
Using evidence-based strategies
We do not speculate with our clients’ money at ProSolution. We only adopt evidence-based investment strategies and invest in assets that are proven to work. We try and take as little risk as possible (there’s always some risk). We don’t invest based on opinions, views or gut feelings. We always want to see strong evidence that an investment strategy, asset class and/or individual investment has worked in the past and that we clearly understand the fundamental reasons that have driven that performance (you must understand what you’re investing in).
In my opinion, this is the primary benefit that an ‘evidence-based investing’ approach provides – a repeatable, reliable, low-risk formula that you can use to build wealth safely. If you would like to know more, please contact us.
