We Want Profits Higher Than Risks

Meir Statman is a Professor of Finance at Santa Clara University. He has gained increasing acclaim in the financial world for his superb work in the field of Behavioral Finance. Behavioral finance studies the intersection of our behaviors (as driven by our thoughts and emotions) and money.

In his 2011 book What Investors Really Want, Statman recounts one telling aspect of the Bernie Madoff story:

“In late 2008, Bernard Madoff confessed that his investment company was nothing but a Ponzi scheme, where longtime investors were paid from the money deposited by new investors.

Madoff’s investors were not unreasonable, surely not in their own eyes. The account statements mailed to George Rautenberg, one of Madoff’s longtime investors, showed annual profits no higher than 14 percent. ‘They weren’t outrageous compared with what Harvard was telling you they were doing and what all those other smart guys were doing,’ said Rautenberg. ‘He wasn’t winning big at all in the good years. He stayed fairly stable.’

Madoff’s reported returns might not qualify as outrageous, but ‘winning’ and ‘stable’ do not reasonably go together, surely not for individual investors such as Rautenberg. We can invest in stocks, reasonably expecting high returns with high risk, or we can invest in bonds, reasonably expecting low returns with low risk.”

In the seven years from 2001 through 2007, “Harvard Endowment had higher returns than those reported by Madoff in five of the seven years, but it [the Endowment] lost money in 2001 and 2002, two very bad stock market years, while Madoff reported gains. Ponzi schemes like Madoff’s are always fueled by the desire for investments with returns higher than their risks.”

It's natural for us to desire profits higher than risks. But there is no free lunch or magic bullet in investing. Invest in broadly-diversified portfolios, accept the risk that comes with owning stocks, and appreciate the role that bonds play in lessening the volatility in your portfolio.

Source: Statman, Meir, What Investors Really Want: Know What Drives Investor Behavior and Make Smarter Financial Decisions.

 

Because The Wealth Group, Austin B. Colby & Associates is independent of Raymond James, the expressed written opinions above are our own and not necessarily reflective of Raymond James’ opinions.