What is 'good'?

Interlude: Concepts behind portfolio building.
interlude

While this module isn’t absolutely necessary, I believe having a foundational knowledge around portfolio design and styles will pay ‘dividends’ (excuse the pun) and make the final module more powerful. Not to mention help you manage your investments far into the future. 

 

The most basic concept that governs almost all of finance is risk vs. reward. You can’t make more without taking on more risk (aka volatility for investors, aka there is no free lunch). However, you certainly can make LESS for the same level of risk…

 

Let’s illustrate this with an example.

Returns Are All That Matter...Right?

Suppose you have $10k to invest and have the option to use Manager A or Manager B. Instead of overthinking it, you decide to give each $5k. 

 

A year later, you go to check on how your investments are performing. 

 

Manager A says your balance has grown by 10%. Pretty great right?

 

Manager B says your balance has doubled and is now worth $10k. Holy crap! 

 

You’re now kicking yourself for not giving Manager B the entire investment. 

 

Now let’s look at the same example with a bit more information….

 

Manager A invested your money in Apple, Google, and Amazon and now says your balance has grown by 10% over the last 12 months. 

 

Manager B went to Las Vegas and put your $5k on black and doubled up. Now your $5k is worth $10k. 

 

Who would you want to invest your money going forward? 

 

Obviously this is an extreme example but the concept is the same. You can’t ever look at just a single performance metric, e.g. 4.5% annual return without understanding how much RISK was taken to achieve those results. 

 

Portfolio design is all about maximizing a return for a given level of risk or minimizing risk for a given return. 

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Dig Deeper:

How inflation works

The Lost Decade (Japan’s Deflation Nightmare) – why inflation is a good thing basically.