Resist the seduction of unrealistic investment returns

User Written by Paul Dodd on February 10, 2015.

Resist the seduction of unrealistic investment returns

Since the dawn of time men and women have been seduced by the promise of great riches, only to be disappointed by reality. Just look at Eve, tempted by a wily snake offering her divine knowledge and doomed to a future of suffering for yielding to temptation.

Succumbing to the temptation of improbably high guaranteed returns on investments may not have quite so dire consequences, but you should nevertheless be wary of the serpents operating in the financial industry in Asia. Certain unscrupulous operators will try to tempt you to invest by promising higher-than-realistic growth projections. It is entirely understandable why the promise of high returns might catch your eye but beware - there will always be a catch.

The fact is that in the current financial landscape, it is not easy to make your money work for you. Since the global financial crisis threw us all a curve ball in 2007, bank deposits have been earning historically low interest. In most cases you can hope to make at best 1% on your money by sticking it in the bank. Small wonder that investors are looking for a magic solution.

Other investment solutions such as stocks, shares and mutual funds may offer a higher return but that higher return always brings with it greater risk. The risk:return ratio forms the basis of the global financial system and you cannot get away from the fact that the higher the possible return, the more you will be risking your money with the very real prospect of financial loss.

If you see advertisements offering a ‘guarantee’ of a surprisingly high return, approach them with caution. There will be a risk element, although it will probably be hidden in the small print. How do I know? Because quite simply it is impossible to provide a fixed rate of return which is significantly higher than the rate of interest without adding risk. The risk could take many guises – examples include currency risk or long term illiquidity – and it may be hard to spot but it will be there.

If you don’t believe me, bear in mind that The Financial Conduct Authority in the UK sets standardised deterministic projections based on 2%, 5% and 8% per annum in its Code of Business and it does so for a very good reason.

There are circumstances where it may be judged that taking on more risk to attain higher returns is a valid strategy but it stands to reason that offering a ‘guarantee ‘ is not commensurate with that investment. How can it be? If such a thing were possible it would be like having a money tree and I haven’t seen many of those around recently.

When it comes to their money most people are risk averse and would rather see their money grow slower and more consistently. The way investment managers do that is by taking a percentage of the investment and hedging it against market falls. Logically that means that a lower percentage of the investment is chasing market rises. It’s a bit more complicated than that but that is the essence of how investment works.

Paul Dodd

Paul Dodd

Posted on February 10, 2015 in Investments.