Wednesday, 25 July 2012

There is no such thing as a free lunch

This is an bit of wisdom that I, and I'm sure many others have heard over and over again yet people constantly seem to forget it when it really matters.  There is really no such thing as a free lunch and you never get something for nothing in the world of finance.

The statement is particularly pertinent is several situations including
  • Spotting scams and dodgy investments
  • Realising that there must be a greater inherent risk to a higher return (no exceptions here)

Spotting scams and dodgy investments
If you always keep the rule that 'there is no such thing as a free lunch' in mind when you invest then you are less likely to be drawn in by scams and 'investments' promoted by unscrupulous operators. 

These scams often draw people in by promising high return, low risk products or guaranteed products with a high rate of return.  This is the reason I was immediately sceptical of the art investment offering a 9% 'guaranteed' income return.

Higher rates of return almost always come with higher risk
If you think you have found a product that offers both a high rater rate of return than the market is offering for the same level of risk (or lower risk) then most often you have either
  • Overestimated the returns:  Even when the headline return appears large often there are caps and caveats which lower the actual rate of return on a product.  For example some warrants issued by large banks for apparently cheap prices actually have a buy back clause if they are too far in the money thus limiting your potential gain
  • Under estimating the risk:  This one is often the easiest to spot if you are looking for it but the hardest to accept if you have mentally sold yourself on the investment
    • A good example is the high fixed income returns that small mortgage lenders used to offer.  They were able to offer this return because they were lending to people with lower credit ratings and thus a higher likelihood of default.  Lots of these lenders went bankrupt and investors lost a large part of their capital value
Note that this does not mean that you should always go for the lowest rate of return - there are some institutions that offer rates well below market value but what you should be aware of is those products which are offering returns well above where the market is.

But I've found this great deal...
Most people think they have the investment which is the exception to the rule.  Occasionally there are exceptions, for example where you have found a seller of a product that is truly a distressed seller and no one else has seen the opportunity.  However these situations are very few and far between.

More likely is that you have not taken to account something that other investors can see.  Note that this applies to all types of investments such as real estate, fixed interest products, art investments and shares (see my example of how you can lose your shirt on shares that 'appear' really cheap).

I always suggest approaching any investment with a great deal of caution.  Always remember there is no such thing as a free lunch and to use one more cliche it is safer to assume that if something is too good to be usually is.

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