The Investment Scientist

Last week I shared an example of how you could still lose money on an investment that gives you a 20% average annual return. I ended the article with five questions:

1. Can the average return tell you if you will make or lose money?
2. Can the average return tell you how much money you make or lose?
3. What else determines if you make or lose money?
4. Why do hedge funds love to use average returns?
5. Why do I use asset class diversification to reduce client portfolio return variability? (Note that this will make the return number look smaller.)

Here are the right answers:

1. No.
2. No.
3. Return variability or volatility. It is also called volatility drag – the higher the volatility, the lower the return. Here is an article on this subject I wrote 13 years ago.
4. It’s great for marketing.
5. One word: I am a fiduciary. (Ok, four words.)

Sure you can! Look at the following stylized example.

Hedge Fund A has a first-year return of 100%, and a second-year return of -60%. The hedge fund’s average return is (100-60)/2 = 20%. But if you have invested $100k in this hedge fund, by the end of the second year, you will only have 100*(1+100%)*(1-60%) = 100*2*0.4 = $80k. In other words, Hedge Fund A gives you 20% average annual return, but you still lose $20k or 20% of your money!

What gives?! Let’s look at the following 6 investments, all of which have a 20% average return. Some are profitable and some are not. All assume an initial investment of $100,000.

Today I finally finished the Oxford class on Private Equity, and I’d like to share with you, my readers, some of my takeaways.

Long-time readers of my newsletter should know that I have long advised against investing in private investments unless 1) you know the business and 2) you have a measure of control. The reason for this is that private investments are not under the purview of the SEC, and thus provide a fertile ground for conflict of interest. After the Oxford course on private equity, I feel completely vindicated.

Some of my readers, if you are wealthy enough, will be approached with private equity investment opportunities. You will be presented with mouth-watering return numbers. My professor called these numbers complete “garbage,” they can be manufactured (but not fabricated.) Fabricating numbers is against the law, but manufacturing numbers is not, and there is only a hair’s breadth separating them. Next time you see a number like 36.8% annual return, think “manufacturing” and don’t waste your time! I will show you how they manufacture numbers in the next article.