July 6, 2023

JF3227: Is the Highest Return Really Best? – Risk-Adjusted Returns | Passive Investor Tips ft. Travis Watts



Passive Investor Tips is a weekly series hosted by full-time passive investor and Best Ever Show host, Travis Watts. In each bite-sized episode, Travis breaks down passive investor topics, simplifying the philosophy and mindset while providing tactical, valuable information on how to be a passive investor.

In this episode, Travis discusses the significance of risk-adjusted returns. Using real-world examples, Travis urges listeners to balance the allure of high returns with potential risks, emphasizing the importance of personal risk tolerance and financial goals.

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Travis Watts: Welcome back, Best Ever listeners, to another episode of Passive Investor Tips. I'm your host, Travis Watts. I have a very critical and fundamental lesson to share with you today. What we're talking about is "Is the highest return really best?" So ultimately, what we're discussing are risk-adjusted returns. Disclaimers, as always, never financial advice; not telling you or anyone else what to do. Please seek licensed advice.

And with that top of mind, most of us as human beings - we're hardwired to want instant results, to want instant fulfillment. And it's also really embedded in our culture. It's why we have all of these stock trading platforms, and diet pills, and get rich quick schemes, and lottery tickets, and all this kind of stuff. But you know, these are not considerations of professional investors like you and I. So let me ask you a quick question... If you had $100,000 to invest, is it better to a) go into a deal where you can possibly double your money over the next 12 months. In other words, you put your $100,000 in, you get $200,000 returned to you at the end of 12 months. Or b) go into an investment where you have a good shot at making a 10% return in the same 12 months. Now, most people think, and a lot of people would tell you to go after the deal with the highest ROI, which stands for return on investment. But what's the problem with that? Well, what if they told you in order to double your money in 12 months, what they needed you to do is put a wet suit on and jump into a pool of great white sharks, where there was a 50/50 chance that you might be killed or severely injured.

So professional money managers, hedge fund managers, portfolio managers, people at the top tiers of the finance industry know how to calculate and discount for additional risk. So what you really want to do is you want to take two investments to evaluate, with the approximate same risk profile, and then go after the deal with the highest ROI.

I remember in 2021, just a couple of years ago, on social media - I post a lot about real estate and private placements and what I do... I had so many people reach out to me that year in particular, when all the hysteria and hype was in the markets, and when cryptocurrencies were hitting all-time highs, and it was in every news headline... And they were asking me, "Do I invest in crypto, or do I have a portion of my portfolio in crypto?" And fast-forward a year later, when most cryptos had fallen 50% to 70% at that point - that's another story... But the answer even back then was "No, I don't, because it doesn't match my risk tolerance and my risk profile." I know what my goals and objectives are. They're very cashflow-focused. I'm a very conservative investor. And there was really no fundamentals to go by in that instance.

So for me, it's never been a play. I'm not saying people haven't made a lot of money in crypto; some people certainly have. Equally so, a lot of people have lost a lot of money in crypto. So the point is, you have to know you, and you have to know your risk tolerance.

So how comfortable are you with losing money? And hear me out - if you're a professional investor long term, you have a high probability of losing some money on one deal or multiple deals over time. So it's not really if it'll happen, it's rather when. But think about it this way - let's consider, what are some of the safest investments someone might be able to make here in 2023? And what comes to mind for me - not saying these are the ultimate things that you or anyone should invest in; just naming examples of things that are generally considered safe. US Treasury bonds. Bonds backed by our federal government; traditionally, they have been labeled as some of the safest investments in the world. Or maybe a CD, a certificate of deposit from a well established bank. Wells Fargo, Bank of America, JP Morgan, something like that, which is FDIC-insured. So let's say you decide to make one of those investments with your $100,000. You say, "Okay, I'll give you my money for the next 12 months", and then let's say you get a 4% annualized return in exchange. So the problem with that is you're only getting a 4% total return. No equity upside, little to no tax advantages, things like that. So the question now becomes, if inflation is 5% and you're making 4%, and you're having to pay taxes on that 4%, are you really making money? Are you really growing your wealth? Are you meeting your goals and objectives that you've set as an investor? I don't know. We're all different. The answer may be yes, but in many cases, it may be a no.

Break: [00:07:01.29]

Travis Watts: Now, in an opposite scenario to that, let's say your brother in law approaches you with a big business idea. He's got a new business venture, he's really excited about launching, he comes to you and says, "Look, if you'll lend me your $100,000, I can give you maybe an 80% return on your money in just one year." So you say "Well, tell me more about the business plan." You learn about it and you do your proper due diligence and what you determine as an investor maybe that's 20 times more risky than putting your money in a CD or a government bond or something like that. Then you would be properly accounting for the additional risk; you would say 4% times 20, 20 times the risk, equals 80% potential return on investment. So it's not about "Is this investment better than this investment?" What really matters is what's your risk tolerance, what are your goals and objectives. So please keep this in mind as an investor when you're looking at deals.

Now, for me, I'm a fairly conservative investor. I invest for passive income, and things that I look for when I do a deal are conservative underwriting, conservative projections, solid fundamentals, track record, background and experience. Ideally, the project would produce monthly cash flow, and have a component of potential equity upside, and ideally, in a perfect world, it would also offer some tax advantages on top of that. So it's why I do a lot of value-add multifamily syndications, or a.k.a. real estate private placements.

Now, I share that with you not to suggest that you should do that, but it's appropriate for me and my risk profile, and my goals and objectives. So something to think about here for the week, risk-adjusted returns.

You're listening to Passive Investor Tips, right here on Best Ever. I'm your host, Travis Watts. I appreciate you guys being here. As always, feel free to share these episodes, by the way, with anyone you think could find value or benefit from them. And if you have any questions or want to take a deeper dive, reach out to me on social media, either Passive Investor Tips, or Travis Watts. I'm always happy to connect, be a mentor or resource to you here in the space. Thanks so much for listening, have a Best Ever week, and we'll see you in the next episode.

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