Most people who have spent any time in college towns or nightclubs are familiar with the phrase “beer glasses.” In a nutshell, this phrase refers to a general tendency for people who have been drinking alcohol to excess to develop highly distorted perceptions of the attractiveness of other people. In these situations, many people find themselves making romantic advances toward people they wouldn’t be interested in if they were sober.
Fortunately, most people mature with age and outgrow the propensity to put on “pint glasses” when they meet their spouse. As we gain more experience, the importance of smart decisions becomes more and more evident. The decisions we make regarding our education, career, and spouse have a lasting impact on our lives. Therefore, it is not difficult to see why it is of the utmost importance to make these decisions with a sober mind.
Unfortunately, there is a distinctive sector of life where many people bring back the “Beer Goggles” in full force. This part of life is investing, and many people get drunk on promises of high returns that lure them into deals that are much less appealing when viewed through sober eyes.
Consider all the late-night infomercials you’ve seen asking you to buy a system that will teach you how to “Buy Real Estate With No Down Payment” or “Get Rich Trading FOREX” or simple exhortations to ditch the dollar and “Buy gold.” The interesting thing to consider is that the people who sell each of these products earn substantial fees and commissions when you choose to buy. What these “systems” trust is that their promises of quick and easy earnings will entice you to send your money.
This isn’t limited to infomercials either. How many people concentrated their 401k portfolios in technology stocks during the 1990s, in energy and financial stocks during the housing boom, and in gold now that the spot price has skyrocketed in response to continuing government budget deficits. Each of these represents a “fad” generated by investors’ enthusiasm for quick profits… not because of fundamentals, not because of cash flow, but because of the simple fact that they expect prices to continue to rise, perhaps as they have in the past.
A common refrain among financial planners is that “trees don’t grow to the sky,” meaning that abnormally high growth rates cannot continue indefinitely. It would be good if many people remembered this wisdom, as the lure of easy profits results in “Beer Glasses” for investors coming in full force. When looking to earn returns on investment, it’s critical to understand that there is no such thing as a free lunch. All investments carry some form of risk:
default risk
Some products, such as bonds, carry a risk of default, in which the issuer is no longer able to pay. Generally, when the risk of default is higher, the interest yield also tends to be higher. This means that high-yielding bond investors are at greater risk of losing their principal. Most investors in government bonds are primarily concerned with protecting against default on the guaranteed principal value of Treasury bonds.
Market risk
Products such as stocks, mutual funds and commodities carry the risk that the market value will be less when they are sold than what they were bought for. This risk is even more pronounced when the security does not pay dividends, because returns are entirely focused on capital appreciation. The volatility of market prices represents one of the main risks for investors in shares or commodities.
Inflation risk
A major risk associated with many investment products is that their returns will not keep pace with inflation or that inflation will significantly erode their returns. This risk factor is especially dangerous for bond investors, since interest payments on bonds are fixed. Because of this, investors who anticipate that current government policy will lead to inflation should look for investment vehicles that are stronger at defending against inflation than bonds.
Liquidity risk
Some investments, such as real estate, produce favorable rates of return from cash flow and leveraged appreciation, but are very difficult to sell quickly without a significant price discount. This means that people who invest in these types of assets should only do so with capital that will not be needed for a long period of time. Problems can arise very quickly if you are forced to sell a property and must discount the price below your loan balance to attract buyers. In this situation, leveraged gains can turn into leveraged losses very quickly.
In the end, it is extremely important that each person takes off their “Beer Glasses” when choosing their investment strategy. Stick to the fundamentals and avoid the urge to chase investment fads or seek quick wins with packaged systems. By ensuring your investment activity revolves around creating value fundamental to paying clients with your capital, you’ll help avoid chasing the elusive quick buck and keep you on the path to long-term wealth creation.
