Last Updated on December 2, 2024
Overview
To what extent do you agree with the following statement: “I will do everything I possibly can to achieve success.”
This statement is very broad, and what classifies as “success” depends on the context.
So, let us reword the statement in the context of investing: “I will do everything I possibly can to achieve superior returns.”
Would you agree with such a statement?
For many investors, the answer may seem obvious: of course! Who wouldn’t want to ensure their portfolio sports the most superior returns, year in and year out?
While there is nothing wrong with trying to create a portfolio that will give an investor the best returns possible (I admit, I am one of those investors who want my portfolio to give me the best possible returns), problems arise when this statement is taken to the extreme.
Again, let us reword the statement one more time, this time with some more provocative words: “I am willing to sacrifice anything for the sake of achieving superior returns.”
Would you still agree with this? I know I don’t, but I know there are some investors who take this to heart.
How Much Risk Can You Take?
Perhaps you have previously heard the saying “High risk, high return.”
Generally speaking, and I mean this in the broadest sense of the word “general”, the above statement is more or less true.
When an investor decides to invest in something, they always run the risk of not getting their money back (I talk about investment risk in another article.)
To entice investors to back ventures that have a high probability of failing, the potential returns offered to investors must be greater than average. This is why junk bonds have such high yields when compared to bonds issued from industry-leading corporations.
If you’ve ever watched Dragon’s Den, when the contestants and investors begin negotiating, the contestants want to give up the least amount of equity possible, whereas the investors want to take on a greater equity stake to offset their investment risk.
Every investor has a risk tolerance. That is, how much investment risk they are willing to take on in exchange for a better return on their investment.
Naturally, there exists a wide range of risk tolerance. On one end you have investors who are extremely risk-averse and may choose to hold a lot of cash and short-term bonds. On the other end, you have investors who can take on a seemingly infinite amount of risk, choosing to invest in very young startups, hold a lot of junk bonds, and have lots of over-the-counter stocks.
Every investor needs to understand what their risk tolerance is and to stay well within that tolerance range.
At the time of this writing, I currently invest exclusively in equities (i.e., stocks), which many investors agree is generally riskier than other asset classes, say bonds or cash equivalents.
I am comfortable with this level of risk because I am confident in my ability to pick companies that have a very low chance of failing (I highly doubt TD or Enbridge will declare bankruptcy anytime soon), and at the same time I can confidently say I can understand all my holdings well enough to detect any red flags well before they reflect in the stock price.
This is a level of risk I feel I can comfortably handle without stressing out too much.
Is the Additional Risk Worth It?
Imagine we are given a choice of investing in the shares of two companies:
Company A has posted a total shareholder return of 10% over the past 10 years. They consistently generate free cash flow, business prospects are strong, and management has been praised repeatedly by investors and analysts alike.
On the other hand, we have Company B, which boasts a significantly higher total shareholder return of 25% over the last 10 years. However, this company has recently found itself struggling to generate consistent revenue, has occasionally posted losses, has had to suspend their dividend because of insufficient free cash flow, and has had their management team replaced more than five times in the last 10 years.
Let’s say we have a very high-risk tolerance, and so we decide to go with Company B, our reason being that we can handle the extra risk in favour of the higher return, not concerned about its weaknesses and other red flags.
Because we have a high risk tolerance, we go on to add ever-riskier investments to our portfolio – junk bonds, micro-cap companies, options, and other exotic asset classes.
With every new addition to our portfolio, we become increasingly uneasy. We stay up later at night, asking if or when this extremely risky portfolio will come crashing down.
We may have assembled a portfolio that promises superior returns, but we begin to feel the stress of shouldering so much risk.
Was the additional risk worth the better returns?
Is a higher return really justified if the investor ends up being glued to their computer or phone, constantly monitoring their portfolio’s every move?
Sure, a junk bond may boast a yield a few percentage points higher than an investment-grade corporate bond, but is the marginal gain in yield justified by the additional stress the investor must now take on?
No investor can keep adding more and more investment risk, ad infinitum.
It’s true that some investors have the guts and capital to shoulder more investment risk than others, but every investor’s resources are finite. No investor has infinite capital, and therefore no investor can take on infinite risk.
There needs to be a point where an investor asks themselves if taking on any more risk is worth the potential gain.
It’s OK to Sacrifice Returns
A lot of investors seem to forget that investing is not a competition.
Just because another investor has better yearly returns than you does not mean you suddenly “lose”.
No one’s going to seize your portfolio or close your brokerage account simply because you underperformed the market or other investors.
Yet so many investors have this mentality that investing is zero-sum, that one investor’s gain is another investor’s loss.
Investing is not a competition, so why do countless investors feel the need to take on high-risk investments? To prove that they are “better” investors?
The sectors I invest in are not by any means “hot”. Energy, financial services, real estate – these are sectors that don’t promise outsized investment returns, but they are sectors I can understand and can confidently select companies I know will be a high-quality addition to my portfolio.
Sure, I can get higher returns by investing in other sectors such as technology, or by choosing to purchase exotic asset classes, but I choose not to because I know I would not be able to sleep well at night thinking about all the investment risk I’d be taking on.
I deliberately choose to forego potentially better returns in exchange for peace of mind, and I am absolutely comfortable doing that.
This is because I don’t believe in chasing superior returns at all costs.
I am willing to thoroughly analyze a prospective investment and monitor it to ensure nothing goes awry, but I do not want to spend all my waking hours watching my portfolio like a hawk.
The world’s most successful and prominent investors don’t spend their entire working day monitoring their investments. I guarantee you that Warren Buffett, Charles Schwab, Seth Klarman, Ray Dalio, and many other high-profile investors don’t look at their portfolios all day, every day.
You don’t need to be the investor with the best returns. Your only competition is yourself, so why stress about how your portfolio is doing relative to others?
Understand that it’s alright to not chase after exotic asset classes if it means your mind is at ease.
If you must choose to sacrifice some returns, but in exchange, you don’t need to stress as much over your portfolio, did you truly lose anything to begin with?
Wrapping Up
Some investors will do absolutely anything to achieve outsized returns.
Even if they stay up at night stressing over their high-risk investments or spend most of their day looking at their portfolio, it doesn’t matter: as long as they have the best returns, they win.
This mindset of getting the best returns at all costs makes absolutely no sense. Investing is not a competition. One investor’s gain is not another’s loss.
An investor is free to pursue as high of a return as they want, yes, but at what cost?
Is a 10% yield offered by a junk bond worth the immense risk when compared to a 5% yield corporate bond?
Is a slightly higher return worth the additional stress and sleepless nights, worrying about what might happen to your portfolio?
Giving up a few percentage points on returns in exchange for significantly less stress is not as crazy as it sounds.
Investing is a long-term activity; you can’t expect to stay for the long haul if you burn yourself out constantly over short-term worries.
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