Friday, April 17, 2009

Speculating vs. Playing it Safe

Few investors think of themselves as gamblers. These days, most of us would be happy to just earn a modest rate of return on our savings, perhaps enough to fund a comfortable retirement someday. However, we often fail to recognize the risks we are taking with our money. For some reason, musicians seem particularly vulnerable to getting drawn into risky, unconventional investments, when in fact they would probably have been better served by the most boring, safe, bland investment choices.

Perhaps it's because we aren't accustomed to having any spare money to invest! For whatever reason, it seems that when a musician runs into a small windfall of cash, he is usually uncertain of what to do with it. And when you don't know what to do with your money, you're most likely to first get wind of whatever the latest investment fad happens to be. A great investor named James Gipson used to refer to this as the "cocktail party test". Generally speaking, whatever "hot" investment people are currently talking about at cocktail parties is probably already at or near its peak, and when any investment has recently performed outstandingly well, it then becomes more likely to perform poorly in subsequent periods. Two recent examples of this are real estate and commodity prices (like oil). Can you recall a couple of years ago when everybody was trying to "get in" on the real estate market? It turned out to be the absolute worst investment available at the time, though it seemed like the best based on recent performance.

Inexperienced investors who place their precious savings into such investments often do so without fully researching the investment first, and without any awareness that such outsized investment performance is almost never sustainable. If you don't fully understand a speculative investment before getting into it, you are violating the principle of good investment diversification, and essentially gambling with your future.

Avoiding losses is more important than boosting returns, because losses are hard to recoup. If a given investment returns -50% this year, then it will have to return 100% the following year just to break even! Of course, we all have to take some risk in our investments, but if you do some research, you'll find that over the long run, some of the most diversified, simple, conservative investments (such as some index mutual funds and government bond issues) provide very competitive returns with far less risk than the latest exciting cocktail party conversation subjects.

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