- August 6, 2018
- Posted by: Trendlab Academy
- Category: Knowledge
The Confusing Side of InvestingBy Carlo Rossi
Imagine you are cruising down the Amazon River in a dugout canoe. A thick rainforest surrounds you on both sides. As you glide along the curved and winding path, you tend to lose track of which direction the river is flowing. Right, left, right, left.
It’s difficult to figure out which direction the river is flowing if you look at it from the wrong angle: one curve at the time as it unfolds. However, should you take an aerial view of the river, you would be able to accurately see exactly where it’s flowing.
Investing is no different. Taking an aerial view means learning how to compute the expected returns and risks of an investment before you make it. It also means to do it for all your available investment options, so as to choose the one with the more preferable return/risk profile.
In other words, you should know the direction each river flows before you embark on a journey and choose one that brings you to your preferred destination. You should know both the destination and the path the river takes to get there.
If you invest without understanding the expected returns and risks or worse, you just trust the computation of somebody else without understanding it yourself, you will encounter three big problems:
- You become easy prey for salespeople who can lead you to where they want you to go rather than where you want to go. This isn’t a small matter, as the fees structure in finance (usually complex and hidden) creates many conflicts of interests that are not easy to detect.
- Your journey will be an unpleasant experience because every twist and turn will create anxiety.
- The zigzags of the journey will mistakenly lead you to believe that you need to change course. This is called the inductive fallacy, which is our tendency to jump to conclusions on the basis of small and meaningless samples.
When you compute the expected returns of an investment you should always look at it as a range of possible returns rather than as a single number. It’s also important to understand the paths of these returns – that is, how and why these ranges of expected returns evolve over time because returns don’t evolve linearly.
Once you do that, not only can you make more profitable investments, but you can also enjoy the journey that your investments will take you to, because every twist and turn will be understood and appreciated for what it is: a scenic ride to a beautiful place.