Investing - Four Problems
To find a good investment one must overcome these four hurdles
In order to make a good investment—one that has a high enough expected return for the risk being taken—an investor must overcome four problems. These are:
Base Case
Replicability
Appropriateness
Execution
Let’s look at each problem.
First, we need to be able to identify what the basic case is that an investment opportunity exists.
Questions in this step include:
Do I understand what the investment is?
Is it ownership or lending?
What would success look like?
How good could it be?
How bad could it get?
What am I missing?
The last question gets at a really important concept—namely, how is this opportunity just sitting there to be had? People don’t leave $100 bills lying on the sidewalk. And just what makes you so special that you have identified one?
This stage is where the biggest mistakes are made—even more than at the appropriateness problem. It is here that investors jump to too many conclusion too quickly. Either they do not understand what they are investing in or they do not understand the likelihood and extent of successes and failures (probabilities and magnitudes), which is the basis for expected return, or they do not understand if this is still an opportunity. Because . . .
Second, we need to know if there is replicability. This has several forms.
If we are thinking about a theoretical investment, we need to know if reality can replicate that theory.
If we are thinking about a prior successful investment, we need to know if it can be accomplished again. You only get to invent Amazon once. The next version faces diminishing returns as well as second mover disadvantage.
More esoterically if we are thinking about justifying an investment that is really a stream of investments (perhaps a private equity hedge fund), we need to know if it can be done again and again and again.1 Otherwise the expected return might be greatly overstated. This is the big problem with internal rate of return assumptions so many in the alternative investment world rely on.
Questions in this step include:
Can this be done; can it be done again?
What must still be the case for this to work?
What cannot have changed for this to work?
Since there will always be differences between theory and reality and past performance and future results, what are the changes and how do they impact the investment case?
Supposing you’ve made it this far, perhaps you are ready for a potentially disheartening truth2. This might not be for you because . . .
Third, we need to know if this investment is appropriate for you. Just because an investment opportunity exists doesn’t mean it exists for all of us.
Investments with positive expected returns nevertheless can be completely inappropriate if their downside risk is too great. Perhaps you have a sizable amount of cash you intend to use in a year for a down payment on a house. Even if stocks look very cheap like they did in 2009, that doesn’t mean investing this money into stocks would be appropriate. The risk of loss is likely still too great to make the risk justifiable for you in this case.
That is just one form of inappropriateness. Another reverses how the burden of risk affects the appropriateness.
People don’t have the same risk tolerances much less other constraints and preferences. Stocks might have positive expected returns over bonds even after adjusting for volatility (market risk) but still not be appropriate for a given investor because stock market volatility is too much for them to take.
Let’s reverse the risk perspective still again. Most investors seek to minimize risk when and where they can. That is one reason young people invest for retirement using stocks more so than bonds. They wish to avoid the risk that their financial wealth does not grow enough to allow a comfortable retirement.
Questions in this step include:
Is this an investment that fits my goals and constraints including but not limited to risk in all its many fashions?
Does this investment work well within my larger portfolio?
Am I rationalizing appropriateness in this case because of FOMO?
Would a failure in this investment be more costly to me than it seems?
Is this something I can reasonably do given limitations specific to me?
These last points allude to the final problem to be addressed. I cannot make an investment that I cannot make—not a tautology because . . .
Fourth, we need to know how to execute this investment.
Some trades are out of reach even though they are perhaps great opportunities. Cost is a factor, but so is liquidity. Finding a counterparty can be difficult and/or expensive.
Suppose you have found a very likely profitable opportunity owning real estate in [obscure, remote, underdeveloped place]. Can you legally and practically acquire it? Can you hold that investment securely over the required time horizon, which may get unexpectedly extended?
Some investments are available only to the rich or certain qualified individuals. Sorry, but that is what our regulators in their wisdom have determined. If an investment requires an owner to be an accredited investor, you may not be “qualified” for it no matter how brilliant you actually are. While certain alternative, private market investments might have already failed our test in stage 3, appropriateness, this can still stop those that do make it through.
And most trades have to be unwound one way or another. Finding a buyer for your asset might be easier in theory than in practice—at least at a price that leaves a good return on investment for you.
Questions in this step include:
How do I gain exposure to this opportunity?
Do I know how to make this investment?
At what cost does that exposure come?
Can I afford it?
Can I own it (legally, practically, etc.)?
Does the cost of execution of the trade(s) risk wiping out the investment gains?
Will you be able to sell what you bought?
Are sophisticated investors, seasoned market makers, or insiders positioned to take advantage of me—in other words, am I bringing a blaster to a lightsaber battle?3
Notice that there are many exit ramps between initial consideration of an investment and ultimately making it. This is a nice feature as we do not always get multiple opportunities in life to say “no thanks” to important questions.
I realize this framework presents investment decision making to be rather arduous, but that is the point. Solving these problems are essential to rational and profitable investing.
Good luck out there.
This guy gets it. Sorry, couldn’t resist.