Sunday, April 13, 2008

Risk Premium - Investment Losses

Let's say you have a choice of buying a FDIC insured CD paying 4% and an Auction Rate Security paying 4.25%, you must understand the 25 basis points premium is to compensate you for taking some risk. If you are unwilling to take that risk, you must give up the 25 basis points.

Now that the bubble is bursting, we are seeing more and more companies going under and investors are losing money on investments in everything from SIVs, Auction Rate Securities, MBS, or even uninsured investments in banks. Although there were certainly instances of fraud, many lawsuits/complaints involve people who fail to accept the fact they were compensated for additional risk.

Rules to Live By:

  1. There is no such thing as a free lunch, especially on Wall Street. Any increase in expected return means you are accepting additional risk.
  2. Do not take risks you do not understand. If you don't understand the risk you are taking, you cannot possibly determine if you are getting paid a fair return for the risk.
  3. If an income investment (bonds, CD's, or other savings vehicle) pays a significantly higher rate of interest than "comparable investments," it is not really comparable. No bank is going to pay 6% on a CD when other banks pay 3% unless there is an enormous CATCH.

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