Most investors expect quite a lot from their investments. Many times their expectations are unrealistic. Should one expect a return of 5 percent, 10 percent, 20 percent or 100 percent? What can an investor realistically expect from his or her investments?
There are many different types of investments and they all offer different features. Does the investor want current income? A high degree of liquidity? Growth of the investment? Income tax savings or deferral? The answers to these questions are very important to obtain before a category of investments is chosen.
How much risk is the investor willing to take? Risk is an important area that one must examine in the light of choosing an investiment. In addition, the investor must also decide if he would feel comfortable borrowing money to purchase an investment (leveraging). There may also be certain types of investiments that the investor would simply feel uncomfortable about. For example, the investor migh just "feel" that oil drilling is not something to invest in.
Another important area for the investor to explore is how much "control" would he or she like to have over the investments? Is it better to have the advice of a professional but have the final say over each investiment? Or is it preferable to have nothing to do with the day-to-day management of investments?
Once these questions are answered and all of these areas are explored, whoever is going to make the investment decisions must follow a certain line of reasoning to develop an investment strategy.
First, there needs to be the development of an economic outlook. Included should be an outlook for the near-term and the long-term. In the near-term, does he or she feel the economy will continue to recover from the recession? Is inflation likely to continue to be as high or even higher? Will interest rates continue to go up?
Once these questions have been answered, investment categories must be chosen that would benefit from the envisioned economic outlook. Subsequently, individual investment candidates must be chosen that would fit the needs and wants of the individual investor. After the candidates have been chosen, the hard part begins.
How can investments be compared with one another? For example, how can one compare oil drilling with cattle feeding or common stocks? Assuming that all of these investments are within the risk restrictions of the investor, one must determine if the potential reward of the investment under study is in proportion to the potential risk.
For example, let's say we have two investments under examination. They have equal risk and both fit the investor's portfolio. How can one determine the potential reward of each to find out which is the better investment? There is only one way. Unfortunately, the way is not an easy one for the novice investor. One must project, as accurately as possible, the potential performance of the investment over the length of time that it is anticipated that the investment might be held. The performance figures must include such items as cash distributed to the investor, proceeds to be received upon the liquidation of the investment, income tax costs and benefits to be derived and the income tax costs to be incurred upon the sale of the investment.
With these figures, a professional adviser could compute an after-tax rate of return on the investment. This rate of return could then be used to compare the investment under study with investments of similar risk.
To show how much such an analysis is needed, I will relate a study that I did a few years back that is typical of many that I perform on tax-sheltered investments. An attorney who represented a general partner of an equipment leasing tax shelter that was available that this investment might be one to consider for my clients, since most are in very high tax brackets.
The investment offered $2 worth of deductions for every $1 of investment. The minimum investment was $1 million, so it was certainly not for the unsophisticated. The law firm representing the general partner was one of the most respected in a large Western city. The general partner has a very good reputation. The equipment being leased was a brand-new IBM computer. The company that was going to lease the computer was a fortune 500 company -- Blue Chip. How could such a deal go wrong?
Well, as one might guess, there was one little problem. When I did the rate-of-return analysis, taking into account the income tax savings of the investment, I came up with a return of -33% compounded annually. Upon making this discovery. I called the attorney who had originally brought this investment to my attention to inform him of my findings and to see if I might have the figures wrong. He said that he would check them with the general partner.
Upon consulting with the general partners, the attorney indicated that his conversation with them had produced a concession on the part of the general partners to guarantee a certain residual value of the IBM equipment after the five-year lease had expired. This news did little to console me for two reasons.
First, the rapid depreciation in the value of data-processing equipment does not lend itslef to high residual values. At the end of the five-year lease the same computing power now produced by the equipment being purchased might be offered for under $10,000 and be offered in a form not much larger than a hand-held calculator.
Second, the subsequent rate of return computations resulted in a return of -9% compounded annually.
The moral of this story is clear. Do not invest blindly in investments that offer deductions.
In summation, the investor should expect a return commensurate with the risk he or she is willing to take and also have the risk/return analysis done by a competent professional.