How to Decrease Risk & Increase Return Part 4

Investing

I see a lot of people who get focused on possible risk while missing out on guaranteed risk, that is to say cases where you are guaranteed to lose money.

It is possible to beat other people in the same market simply by minimizing or eliminating these guaranteed forms of risk.  Most people reading this are probably sitting there saying “What’s he talking about guaranteed risk?”  After all, who would invest in a way that they were guaranteed to lose money?  The reality is the majority of people do it without knowing it.

So let’s ask, what are these guaranteed forms of risk in most investments?  Some might argue fraud but that’s not what we’re talking about.  Some might argue paying more for something than it’s worth and that’s fair, but not really what we’re referring to here.  There are two ways primarily that you are guaranteed to lose money that can be mitigated to some extent, they are taxes, and fees.  What then is the rule if we want to decrease risk and increase returns?

Minimize taxes and fees

Before I continue on let’s be careful because some fees actually add value so being able to sort out where value is added or not is an issue.  It’s also a fact that the people who help us need to earn a living as well so it’s fair to pay some fees on some transactions.  However, there are also a lot of fees that don’t add value, and a lot more fees that can be avoided.

Let’s talk specifically about fees and what kinds of fees can show up in most retail investments, since this is what most people invest in:

  1. Marketing fees – different investments pay these out in different forms but you can’t get around the fact that every investment needs to be marketed and consequently you’re giving up your returns by investing with them, in the exempt market these budgets typically range from 10-15%, meaning they have to get a rate of return with just 85-90% of your money (remember what we said about the impact of losing money?)
  2. Administration & Management fees – this includes everything from picking the investments, to doing research, getting approvals, paying for office space, paying to send correspondence to the investors, paying for recruiting, management, computers, phones, office supplies, legal structuring, accounting, etc. these vary wildly but a typical mutual fund will charge about 2.5%/yr. of the money under management whether you make money or lose money that year, private equity firms tend to charge 2%/yr., other companies bury the fees all over the place but the point is it hurts your rate of return
  3. Transaction fees – a lot of people don’t realize that what’s called MER (Management Expense Ratio) in mutual funds doesn’t cover the actual transaction fees when buying and selling individual stocks, a similar fact is true for realtor fees when buying and selling properties
  4. Profit – don’t forget that in addition to the fees the people offering and managing the investment need to make money so they are going to take extra out for themselves, in venture capital and private equity this is typically 20-30% of the profits, again, it can vary wildly from one investment to another

All of these fees added together it is very reasonable to expect that in a lot of investments they can reduce your returns by 50% or more, which is partially why it is almost impossible for investors to get a consistent rate of return in excess of 15%/yr. because to get an actual 15%/yr. means the company needs to have generated at least 30%/yr. which is wildly unlikely in most cases on a continual basis.  This is also why learning to invest yourself and investing yourself gives you an intrinsic advantage, though of course you have to factor in the cost of your time to learn it, to do it, etc.

Bottom line, you can often increase your returns simply by decreasing or eliminating  lot of these fees, consider that a 10% marketing fee effectively reduces your investable capital by 10% compounded over the term of the investment.

What about taxes?

Some people will say “the only guarantees in life are death and taxes”, this might be so, but there are definitely ways to reduce those taxes.  The most common ones come in essentially 4 different forms:

  1. 401K, TFSA, RRSP, Permanent Life Insurance, etc. – investment vehicles designed by the government to help tax shelter your money (may vary by country) can increase your returns simply by decreasing your taxes
  2. Write offs – by paying attention to your legal structure when investing you can get write-offs to decrease your taxes (for example you can write off certain expenses against rental income on a rental property)
  3. Capital Gains & Dividend Income – there are various types of investments that are taxed differently, by paying attention to the tax type and factoring it into your rate of return calculations you can increase your income (this can also be done through flow through shares though they need to be evaluated carefully)
  4. Sourcing Income In a Lower Tax Jurisdiction – on the extreme level this can mean moving to another country with lower taxes (Sir John Templeton the famous billionaire founder of the Templeton fund is famous for this), or setting up a legal structure in another country with lower taxes though this requires careful planning, but could also mean moving income to another province or state within your country where tax rules are superior (Tony Robbins is famous for having left California to avoid the high taxes there).

There’s a lot to be said about taxes and they really need to be evaluated on a case by case basis but suffice to say this can be a significant source of lost return.  For example, an 8% return if taxed as interest income at the highest rate (approx. 40%) becomes only 4.8% after taxes and you can earn that with guarantees inside a life insurance policy.

One particular way people incur excess taxes and fees though is worth noting, or rather there’s one way you can really minimize taxes and fees while at the same time making your life easier:

Avoid money churn

Think about those marketing fees discussed above.  Every time you sell out of one investment and buy into another investment you incur those fees.  You also incur taxes every time you sell.  Why is this so bad?  Because it undermines your compounding, it can actually be compounding in reverse.  If you can find great investments and hold them for as long as possible you’re in the best position.  Every time you can avoid churning your money you have effectively decreased your risk and increased your return.  This is partially why Warren Buffet aims to hold most of his investments for decades, he has deferred tax bills in the billions but so long as his money keeps growing in the same investments as before he doesn’t need to worry.

If you’ve got investing questions you’d like to discuss or like us to cover please click "Ask a Business Question" in the lower right corner of the screen to send it to us, looking forward to hearing from you.

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