In February, a client showed me a newspaper ad from an investment firm that showed a 47-per-cent return on their client accounts in 2011. “Let’s buy some!” she declared enthusiastically.
Although it would seem easy to jump on the bandwagon and get a great return just from answering an ad, think again. Professional marketing departments cherry-pick portfolios with great returns hoping to quickly increase firm assets. They know that it is human nature to look at short-term investment returns and that people tend to believe historical returns will continue into the future. However, this is rarely the case.
Usually when a specific investment achieves a drastically different return from the broad market, they are highly concentrated in one specific asset or asset class. The investment fund in the advertisement above was probably invested heavily in gold or risky corporate bonds, and maybe even borrowed money to further juice its performance.
Don’t get me wrong, I don’t think having gold or corporate bonds in your portfolio is a bad strategy, as long as it is not the majority of your assets. Exposing yourself to risky assets in small doses is not a bad plan, however a big mistake that investors make is “putting all of their eggs in one basket” and having the majority of their portfolio focused in one sector of the market.
Most of the time, the hot investment of the previous year turns out to be the dog of the current year. As a rule of thumb, if your retirement account is considering an investment strategy that has an expected return of more than seven per cent, you could be taking too much risk.
Companies publish these ads because they know we are wired to be more sensitive to short-term than long-term gains. The ad executives know this, and that is why you see so many ads touting shorter-term performance. One-, two-, or three-year returns dominate investment firm ads, with the firm selecting the best one or two portfolios to publish that year, sometimes choosing from hundreds of funds to find the few that performed well over that time period. If done well enough, it can result in millions of dollars of new deposits for the firm.
There is one sure thing in investments: low levels of risk are associated with low potential returns. High levels of risk are associated with high potential returns. You cannot break this relationship, not ever. Risk can mean not only loss of capital, but complete loss of your investment.
The truth is that you should not pay any attention to investment industry ads. Prospective investments should be thoroughly vetted before considering putting your money there. And remember there is no “free lunch” in investing. A high return goes hand in hand with high risk, even though sometimes the risk part of the equation shows up later. If you cannot understand a prospective investment, or if your investment adviser cannot explain the investment strategy in plain language, you should probably steer clear.