Risk Versus Reward With Your Capital

Posted by Jeff Carter
on August 22nd, 2012

If you have a pile of capital sitting around, you know, one of the one percent. What do you do with it?

Economists study this problem constantly. They view it through different lenses, but what you do with that capital comes down to costs vs opportunity costs. It always does and is one of the first concepts you learn in economics. Costs vs Opportunity Costs are the yin and yang of economics. The positive and negative fields. Once you make a decision, other decisions aren’t available to you. Velocity of money is like that. That single dollar sits in space until it moves. The calculus that moves it is what makes life interesting.

For high net worth individuals looking at the different places to put money today, what is their calculus? Each decision has a consequence and eliminates others. There are Bonds, Stocks, Yourself/Startups, and Mattresses/MasonJars.

There are bonds segmented into three areas; Treasury, Corporate and Muni. At this point and time, the risk/reward for US Treasuries stinks. You get no return, especially after taxes and inflation. The only good news is if you put $1M in, you will get $1M out assuming the US government doesn’t collapse. That $1M will be worth less than you put in, because of the time value of money and the rate that the money supply is increasing thanks to the Fed. I think we can agree if you are trying to grow, US Treasuries are shitty.

Muni bonds might be even worse. Higher returns, especially because of tax advantages. But do you want to take a risk on certain municipalities right now? Investing in Munis is work because you are going to have to do some due diligence and really check out the city or entity you are investing in. Plus, as cities and counties go bankrupt, there might be domino spillover effects that you don’t see.

Corporate bonds seem like the safest investment in a bond portfolio today. Pick a good company, try and get a good inflation/tax adjusted return. The only downside is if you pick the wrong company you are screwed. Or, if you pick a company that is likely to get a bailout from the Federal government, the government may run roughshod over you and pick your pocket like they did to the GM ($GM) bondholders.

So, the 1% put some money into Corporate Bonds, some rainy day money into Treasuries.

Historically, stocks are the best place to put your money. Great returns over time. However, a lot of people have soured on the stock market. The return over the last ten years is flat. In addition, because of certain economic events, the stock market always feels like it could topple at any moment. But the risk/reward towards putting a lot of money in the stock market feels a little better right now. Especially if your time horizon is long. The Fed has cheapened money, bonds are crap(see above) so money should be flowing to the stock market.

Why isn’t it? Money is coming out of the market. It sits on the sidelines.

I think the reason for that is that the government has monkeyed around so much with different parts of the marketplace for so long that people have simply lost confidence and given up. Since the tail end of the Bush administration, instead of worrying about earnings we are worried about committee hearings and bills. Just the other day, Obama announced a buyback of meat and different stocks were affected.

SFD data by YCharts

There is no way to quantify this sort of government risk. It happens out of the blue. That combined with a general hatred of Wall Street, the flash crashes, the mishandling of popular IPOs, the fleecing of customers in the MF Global+PFG instances, make the public ever wary of the stock market.

That all being said, you should have your money in a fund that replicates the S&P 500. It is efficient market hypothesis investing and takes away some of the risks. Since most of the government risk only affects the market for short periods of time, unless it’s a quantitative ease or something like that, you should be okay. So the wealthy are still in the market.

The Mattress route is just putting it in a savings account and letting it sit. This is very unproductive and doesn’t bring you anything. The only good news about this is that you still have options.

That brings us to yourself/startups. Invest in yourself is always the best option for your money. The opportunity cost equation is good, because the time and money you invest in yourself stays with you until they put you six feet under. Learn a new skill that you can take and be productive with. Get a degree.

The other option here is risky. Invest in a start up. For a single individual, the most efficient way is to join an angel group. The reason is the power of numbers to analyze a deal. Good angel groups will have diversity of thought and opinion in them that will cause you to think out of the box and make better investments.

Or, you could say, “I don’t have time for all that.”. Then put your money in a fund that concentrates on start ups. Getting down the learning curve of angel investing can be time consuming, hard, and expensive! Putting your money in a fund lessens some of the risk. Because start ups have done better than the stock market, people are looking at this option. VC has not done as well as the stock market, so the trend is shifting. The smart money is going smaller and earlier.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.