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Decrease Your Risk by Understanding Your Investments

I was getting caught up on my feed reader yesterday. Lots of people discussing the Madoff scandal. One such post was this wonderful one by Aswath Damodaran (a Finance Professor at NYU). Here’s what I really liked:

There are two questions that we can ask about these investors [professional money managers]:

a. How much money (returns) did a particular investor make over a period or periods?
b. Why did they make the returns that they did?
As Aswath notes, we tend to get drawn into answering the first question, while ignoring the second (especially if the answer to the first question is a good one!). And this isn’t terribly surprising.

  • The first question is easy to answer, and it’s easy to use to compare various money managers.
  • The second question, on the other hand, is easy to discount due to the fact that it’s necessarily going to be answered in far less objective ways.

If you’ve spent any time reading the purported strategies of mutual funds, you know that the bulk of them are nearly identical (“Invest in proven companies that are leaders in their industries,” “Invest in equities that we feel are attractively priced,” etc.). Given how similar–and how obvious–these statements are, it’s no surprise that we don’t put a lot of value in them.

However, to ignore them is a mistake. Before turning our money over to somebody, it’s important that we know what they intend to do to earn their pay. (“Their pay” = the excess of their costs over the costs of an index fund). And if their argument isn’t convincing–or if we don’t understand it–why entrust them with our money? There are always other options.

As Warren Buffett says, “Risk comes from not knowing what you’re doing.” If we’re going to turn our money over to somebody, let’s at least make sure we understand what they’re going to do with it.

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Comments

  1. Dustin McClure says:

    I agree – never invest in anything you don’t understand.

    Once you understand your investments you won’t be in the dark and you won’t worry so much.

    Thanks for the article.

    Good Tips

  2. People didn’t care to investigate how he was generating returns that no one else was able to duplicate. Madoff’s investments were up over 5% this year when almost everyone else is down substantially.

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