Don’t Forget To Do a Risk-Benefit Analysis When Investing
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Whether or not you’re conscious of it, every decision you make in life involves a risk-benefit analysis.
Whenever you decide to get in a car and drive to work, you’re taking a risk. However, the benefit of getting to work far outweighs whatever risk you perceive is involved with driving.
If someone asked you to climb Yosemite’s El Capitan without safety ropes, any benefit probably seems less worth it considering the amount of risk you’d have to take (unless you’re Alex Honnold).
As physicians, we perform a risk-benefit analysis when making clinical decisions. You might decide to perform a certain surgery for the benefit of a patient. There are surgical and anesthetic risks, but the benefit outweighs the risk, so you decide that’s the best choice.
Even when deciding to do nothing and stay put, there’s a risk that you’re taking—the risk of inaction.
Risk-Benefit Analysis and Risk-Adjusted Returns
Unfortunately, some physicians do not perform the same type of risk-benefit analysis when it comes to making investments. I know I've been guilty of this many times throughout my life. I've gotten lucky on occasion, but I've also gotten quite hurt at other times.
Quick question: You have two places to invest your money; one predicted to make a 10% return and another predicted to return 20%. Where are you going to invest your money?
Well if you asked me a few years ago, without asking too many more questions I would've pushed for the 20% returns and you would have had to seriously convince me to choose otherwise. Chasing high returns is both fun and exciting, but let’s not forget about adjusting for risk. This concept is known in the investing world as understanding risk-adjusted returns.
What Is Risk?
Risk is simply the possibility of loss or injury. In an investment, risk is typically the chance of loss of capital or value. In general, as the amount of risk in an investment increases, investors expect higher returns to compensate for taking on those risks.
“In its simplest definition, risk-adjusted return is how much return your investment has made relative to the amount of risk the investment has taken over a given period of time.” – Investopedia
This basically means that if you take two investments that have similar returns and look at them over the same amount of time, the one that has the lower risk has the better risk-adjusted returns.
Is there a way to quantify the level of risk and therefore the risk-adjusted returns?
In the investing world, people have come up with all sorts of metrics and defined different risks, particularly when it comes to the stock market. When looking this up, I discovered such metrics as the Sharpe and Treynor ratios. There’s also a ratio, Beta, which tracks how volatile that investment is compared to the overall market. This is an indicator for overall systematic risk.
Other factors to think about include the amount of time before you receive your returns, your ability to access your money (liquidity), and whether there is collateral involved.
However, in reality, how many people are calculating these ratios especially when looking at different investments like real estate, angel investing, etc. Is that even possible to quantify in most scenarios?
In reality, we have to do the best job on our own to figure out all the risk factors and understand where this particular investment sits on the risk-reward pendulum.
So when we consider the current environment—interest rates on the rise, volatility in the stock and labor markets, trade and tariff wars heating up, global instability—how are we supposed to know what risks are worth taking?
Well, the truth is that no one can make predictions with complete accuracy, but there are things that you can do to minimize the chances of making a single poor decision that will completely hurt you in the end. These include:
- Understand the multitude of different investments you can make both across and within investment classes.
- Understanding the investment in front of you as best as possible and learn how to do the proper due diligence. If you’re investing in syndications, understand how to vet a sponsor and the deal itself.
- Diversify, diversify, diversify.
My Next Investment and the Capital Stack
So what am I doing in this current market environment? I can tell you one thing I'm not doing – sitting on the sidelines. To me, money that is sitting with no purpose is dying money. It is getting eroded by inflation. So, I'm still investing, but I'm being more careful about looking at risk and thinking about risk-adjusted returns.
One of the best tools to understand risk in real estate is understanding the concept of the “Capital Stack.”
In general, financing for a real estate investment opportunity is structured like the pictured example. Debt is the largest component and is always paid back first. As returns are generated, the bottom of the stack is paid back and it increases to the top.
So, holding the debt note (like a bank) is considered the safest place to be in an investment. They receive the first returns as well as hold the first position in terms of the collateral. However, the returns are also the lowest on the stack and there isn't any upside potential as opposed to the equity positions.
So in summary, returns increase as your position is higher on the stack, but so do the risks.
In my portfolio, I hold plenty of equity positions in many crowdfunding and syndication deals. With these investments in the current environment, I'm typically looking for returns from 14-18%.
However, in looking at my portfolio I realized that I have very little in debt positions. Again, the goal is to diversify my investments, even within real estate.
So I've been looking around for such an opportunity and have decided to invest in a debt fund found through the crowdfunding platform Alpha Investing. Because of regulatory issues, I can only share basic details.
The fund is managed by a highly established real estate company that has originated billions of dollars of these loans since the 1970s with great success (never suffering principal loss). Without Alpha Investing, I would normally not have access to this investment.
The returns projected are in the double digits annually with an annual liquidity option, meaning I have an option to remove my money each year. To me, that's a huge benefit, and one not always a part of investing in a real estate fund. Adjusting for risk, this is the type of risk-adjusted return I'm looking to add to my portfolio… so I will.
Investing Is a Marathon
Again, we have to remember that getting to our goal is not a sprint, it’s a marathon. Sure, we’d love to strike lightning by angel investing or by picking a huge stock winner, but without balancing for risk and diversifying our portfolio of investments, we could find ourselves in trouble.
So, whenever we look at returns, we have to remember to simultaneously look at risk to figure out where to best invest our capital.
How are you adjusting for risk in your investment portfolio? Find the Passive Income Docs Facebook Group and share your thoughts!
Disclaimer: The topic presented in this article is provided as general information and for educational purposes. It is not a substitute for professional advice. Accordingly, before taking action, consult with your team of professionals.