“This is not investment advice.” is the phrase you come across frequently navigating any media dealing with investments. It is also the source of frustration for many of my friends where the conversation goes something like this:
“Do you own [xyz]?”
“yes”
“Think price is going up?”
“yes, probabilistically speaking”
“Should I buy it?”
“Not sure, it depends on your investment objective.”
“But you just said you think the price goes up?”
“Yes, but I cannot give you investment advice.”
Afterward there is usually some further back and forth that ends in a phrase said in frustration that basically sums to:
I just want to make some money.
Before I dive into why it is not investment advice, unless specifically from someone you have engaged to give you investment advice, let me tell you this with the same level of conviction I have about the existence of the sun and the moon:
No one, and I literally mean no single human being alive or ever lived, can tell you whether purchase of an investment is guaranteed to make you money.
If they do, run away. They are either delusional, or running a Ponzi scheme. No exceptions.
Now that we got that out of the way, let me state why that phrase should always be included, is frequently ignored, and occasionally frustrates audiences:
All investment decisions need to be made in a portfolio context.
If you are the finance type, you may refer to this simple rule as portfolio construction, or risk budgeting, or portfolio optimization. Any investment decision requires three vital inputs: target returns, risk tolerance, and constraints. Let’s see what each means with concrete examples:
1- Target Return
Target return is not a choice per investment. It’s a portfolio decision, i.e. it includes all of your investments. Sure, each investment would include a target return, but it is the impact of the inclusion of any investment in the portfolio that is important. No matter how bullish you may feel about the hottest tech stock, if the entirety of your stock portfolio is technology, then it is more likely than not that adding another tech name is not the right decision.
Modern Portfolio Theory is one of the simplest portfolio construction frameworks which got its inventor the Nobel Prize. It demonstrates mathematically the old adage that “putting all your eggs in one basket” is a terrible idea.
It is still one of the most widely used frameworks. One of its best insights that is at first counterintuitive, is that including inferior investments with lower expected returns is optimal if they reduce the overall risk of the portfolio measured by its volatility.
2- Risk Tolerance
Surprisingly this is a hard one to explain. For any single person, your financial worth is not just how much money you have. Your net worth should be viewed as your investments minus liabilities plus your human capital.
Think of human capital as the present value of your potential lifetime earnings. All else equal, who do you think has the higher human capital here: An investment banker earning 250k a year, or a surgeon earning 250k a year?
The investment banker’s earnings likely consists of mostly a bonus, which is often discretionary, fluctuates with swings in the financial markets, likely has a vesting period, and is far more likely to be fired in an economic downturn than a surgeon.
The investment bankers should invest in safer assets uncorrelated with their income stream, such as unlevered real estate. The surgeons with a large and fairly certain human capital ahead should use leverage judiciously and invest in far riskier assets such as venture capital. Yet, in reality the portfolios I see are the exact opposite of what they should be.
3- Constraints
Constraints are not just about being able to access investments. The accredited investor qualifications required to invest in private funds in my view are well-intentioned, but outdated, regulation that over the years have made many of the best investment vehicles inaccessible to the average investor. Leaving out the obvious constraints such as legal, geographical, and accessibility constraints aside, there are also considerations for things such as cash flows, tax, and liquidity that are often ignored. If you are carrying any high interest credit card debt, it really doesn't matter how much you think your next hot tip is going to rip. Pay your credit card debt first.
Final Words
I know it can be frustrating to hear phrases such as “it depends”, or “I cannot give you investment advice”. Next time you hear them, take comfort in knowing that it said with good intentions and a healthy understanding of portfolio management theory.
Oh, and duh, also as a legal disclaimer in case a securities regulator comes knocking… :)
This article was originally published on Medium.