Posted by: Robert Hutchinson
December 22, 2006

RATE OF RETURN: THE REAL AND THE RIDICULOUS

What is one good way to detect that an investment is shaky? The answer is by looking at what the rate of return is going to be. Put another way, if someone tells you are going to get a fantastic rate of return, the general rule is run, not walk away. Will Rogers had it right when he said that return of principal is more important than return on principal.

A key thing to remember is that risk and reward usually comes down to this: The higher the return, the higher the risk. To some this seems obvious, but many "sophisticated" people forget this immutable rule.

What is a reasonable rate of return? Legendary investor Warren Buffet and cohort Charles Munger state that 11% is a very good return. Assuming the usual inflation rate is 3% annually on average, that means 8% above inflation. That figure is likewise cited by Frank Armstrong III, author of the Informed Investor. Wall Street guru Peter Lynch agrees that lower returns are the norm and goes one step further by pointing out that if one could get something in the area of a 20% return each and every year, then that person in due course would own the world! Many feel that going forward, the stock market will not replicate the big returns of a few years ago, and so the overall return will be something less than 8% plus inflation.

So when people offer an 18% return or 25% return or 40% return, it will probably (a) never happen, and (b) if it does, it probably will not be for long. There are notable exceptions, but the difficulty is to find them, a problem that vexes even expert money managers. The idea of having a widely diversified portfolio is based on "Modern Portfolio Management Theory" taught in all the business schools, which holds that different asset and bond classes should be "countercyclical" to one another, so that when one goes down the other (s) will go up, thereby smoothing out the returns. Put another way, the investments should be such that when one class goes down, the whole portfolio will not go south. In other words, a risky investment, if done at all, should be only a small per cent of the whole.

People who don't understand these principles get taken in all the time. Businessman Joe Coors, Jr. of the Coors Brewery family is a recent example. He and others were approached by a group who said their investment would bring a 75% return a week, getting back to the idea that if that were true, then Coors could expect to own the entire world in short order. Investors were required to invest a minimum of $10 million dollars and to keep the investment secret. Naturally the investment went south, and on February 11, 2005 one of the promoters was sentenced to 15 years in federal prison.

The Rocky Mountain News on August 26, 2006 ran a story that originated from Bloomberg News 2006 on Kirk Wright of Marietta, Georgia, recently indicted on 24 counts of securities fraud and mail fraud. An estimated $185 million dollars of investors' money has been allegedly been lost, including investments from various present and former Denver Bronco football players. Wright told investors in his hedge fund that he could produce annual returns in the area of 27% by short-selling stocks. Meanwhile, the FBI and court appointed investigators are trying to figure out where the money went. These kinds of real life stories, as we all know, are endless.

Why do people invest in such things? The biggest reason is that they don't understand how risk and return work, they don't understand what a reasonable return is; and they don't understand a lot of the financial rules in play. Why? The answer is simply that it is not what they do.

There is another reason, and that is fear. People are often scared into the idea that they won't have enough money to retire if they only have a "small" return of 11% or less, and so they are told that they "need" a bigger return. In a perfect world, that kind of reasoning might be valid, but in the real world it is not. So that kind of sales pitch is pouring gasoline on the fire making the problem worse not better.

Often investors feel ashamed when they get taken,when that nest egg gets reduced to nothing or takes a big hit. But they shouldn't. The investment advisor and broker are the ones that should be ashamed. The problem is sometimes made worse when this shame prevents him or her from contacting an attorney. When that happens, the possibility of recovery is lost, making a bad or terrible problem hopeless. Since there is no reason to be ashamed, there is no reason not to act.

Why do people sell these things? As we all know, there are a fair number of con artists and swindlers out there. There are also a lot of incompetent investment advisors and brokers who have no training in knowledge of these principles of investment and finance, and who certainly don't receive any meaningful training by many brokerage companies, including some of the biggest ones. Many companies reward their people, not for their knowledge or expertise, but rather for their ability to generate commissions - those who can rack up a lot of transactions - these are the so-called "big producers." Then of course, there are those who actually do understand risk and return, but push their clients into a lot of risky deals in order to pick up a commission, and some would say these folks belong in the first category.

Let's get back to Warren Buffett, who is probably the most astute investor of all time. What is his investment strategy? Is he on the roller coaster of high risk deals? Is he constantly buying and selling, generating big commissions for his broker? The answer to both questions is no. His strategy is one of "buy and hold" for the long term. He looks for what he calls a "margin of safety." Like Will Rogers he is much more concerned about return of principal rather than return on principal. And we know what his idea of a good return is. That "small" rate of return has protected his money and made him a multibillionaire.

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