With the maze of investment choices and vehicles available today, both to individuals and business people, what yardstick would be appropriate to gauge their relative merits? Some people make their investment decisions based primarily on rate-of-return, while others deem safety of paramount importance, and still others are concerned with the tax aspect of an investment or business decision.
While these investment standards and measuring tools are important, they should not be the deciding factor in basing your investment or capital expenditure. The most important investment criterion, whether you are purchasing a stock, bond, or another business, is the suitability of that particular investment in relation to your financial psychology or business makeup (your core business). No matter how good an investment may seem, if it doesn’t agree with your basic comfort level, it isn’t suitable for you.
A business example that illustrates the role of investment suitability is the misadventure of Pacific Enterprises Corp. In the l980’s Pacific Enterprises, a large utility holding company in southern California, bought the retail drug chain Thrifty Drug Corp. (now part of Rite Aid). The company thought they could easily transfer their expertise of managing a utility over to the retail drug business. Bad decision! Not only did they overpay for the retail drug chain; they knew nothing about the unique problems of managing a retail drug establishment. They simply got too far afield from their core business. Their losses started to grow and the company’s stock value plummeted. Pacific Enterprises eventually was forced to sell Thrifty Drug Corp. at a sizable loss. The investment they made in Thrifty was not a suitable one when compared to their core business.
You probably read where many individual investors jumped onto the dot.com bandwagon hoping to make their fortunes. Unfortunately, many of these same individuals never assessed whether the dot.com companies would ever turn a profit and if these particular investments were in harmony with their investment profile (suitability again). Obviously not! The dot.coms have had their day in the sun. Many are either out-of-business or selling at a fraction of their initial price. It is one thing to offer a new business technology; it is another thing to translate it into profits and, more importantly, positive cash flow.
Rate-of-return is important in that it can be used to gauge suitability of an investment. Before committing to any investment, it is important to quantify the potential annual rate-of-return. This number will give you a relative “feel” of the level of risk involved.
To gauge this level of investment risk, take the interest rate on 10 year U.S. Treasury notes and add four percentage points to it. Rates-of-return that are equal or exceed this range are deemed risky investments. For example, the current interest rate on ten year Treasury notes is about 4.0%. Therefore, investments that may have a return in excess of 8% carry a higher potential risk. These investments may or may not be suitable for you.
You have to determine the level of risk you are comfortable with. But always remember this important investment rule: the higher the rate-of-return the greater is your risk of losing your capital. There is no such thing as a free lunch.
My latest book is The Thirteen Great Economic/Business Myths That Dominate Our lives.The book is available on most popular book web sites (amazon.com).