The THREE GOLDEN KEYS OF SUCCESSFUL INVESTING. What the World s Best Investors Know and Aren t Telling

Transcription

1 The THREE GOLDEN KEYS OF SUCCESSFUL INVESTING What the World s Best Investors Know and Aren t Telling

2 The Three Golden Keys of Successful Investing What the World s Best Investors Know and Aren t Telling James Skinner, Roice Krueger, and Mark Victor Hansen will tell you what professional investors know and what amateurs learn the hard way! 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 1

3 The Authors JAMES SKINNER is the founder of two global financial groups that manage billions of dollars of assets. He is also recognized as one of the world s foremost business thinkers and appears regularly on Japanese television. ROICE KRUEGER co-founded Franklin Covey, the world s largest training company, and has supervised consulting projects for 80 percent of the Fortune 500. MARK VICTOR HANSEN is the co-creator of the Chicken Soup for the Soul empire and is the best-selling nonfiction author of all time. His goal is to make the planet work for all humanity! NOTE: Ideas That Can Change Your Life is a collaboration of three of the world s most amazing authors, speakers, and thinkers. The first person I may refer to any of the authors. 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 2

4 Foreword There is no foreword to this book. The markets don t have time for that! Neither do we. Let s get right into it! James Skinner, Roice Krueger, Mark Victor Hansen 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 3

5 The First Golden Key: Risk The only thing you ever get paid for in investing is risk. You are paid to take a risk that somebody else does not want to take. That is the only game in town. Risk is merely the possibility of an undesirable event occurring. People are willing to pay you to take on the possibility of an undesirable event happening to you, rather than holding on to the possibility of that undesirable event happening to them! When you put money in the bank, is there a risk? Yes, there is a risk. How do you know? Because they pay you for doing it! 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 4

6 It really is that simple. If you get paid, you are getting paid because there is a risk. If there were no risk, you would have to pay them for safekeeping your money. So what is the undesirable event that could happen? The bank could go bankrupt and not be able to pay you back. A lot of banks could go bankrupt on the same day, and the government could default on its obligation to insure your deposits. Now the likelihood of that happening seems small, so the return you get on your investment is also small! Now you know why you don t get much interest on your savings account. If you put your money into a time deposit at the same bank, is there more risk? Yes! 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 5

7 How do you know? Because they pay you more! It really is that simple. Bankers are brilliant. After all, they have been doing this risk thing for thousands of years and have learned a thing or two about it along the way. You deposit your money in the bank. The bank then loans that money to somebody else. They charge that person one interest rate and give you another. The difference is theirs to keep. Savings deposit: Pay 2.5 percent interest Loan: Charge 7.5 percent interest Bank s profit: 5 percent of your money every single year! 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 6

8 The bank doesn t want to risk loaning out its own money, so it pays you to take the risk. It loans out your money instead! Now banks are really clever. They get the government to insure the deposits, which reduces your risk, and thus reduces the amount of money they have to pay you for your deposits. Basically, the taxpayer subsidizes the bank! The taxpayer pays for most of the risk, so that the bank can loan out money at a profit. No wonder banks always have the biggest and best buildings on all the prime real estate in every city in the country! Don t Minimize Your Risk! Most investors are taught that when you invest, you should minimize your risk. This is stupid! If you minimize your risk, you minimize your return! Get it? 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 7

9 Risk Is Not One Thing Everybody keeps talking about risk as if it is one thing. It s not. Once again, risk is merely the possibility of undesirable events occurring. Since many undesirable events are possible in our lives, risk is not one thing; it is many things. In investing, we look at many types of risk, which is just another way of saying that there are different things that can go wrong with an investment: 1. Capital risk (risk of losing your money) 2. Volatility risk (risk that the price will go up and down) 3. Liquidity risk (the risk that you can t get to your money when you need it) 4. Credit risk (the risk of a counterparty going bankrupt) 5. Regulatory risk (the risk that laws, regulations, and tax rules may change) 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 8

10 6. Currency risk (the risk that the currency that your investment is in $, \, may change in value) 7. Country risk (the risk that the country you are invested in may become unstable: war, change of government, etc.) 8. Reputation risk (the risk that your reputation will be ruined by associating yourself with a particular investment 9. Event risk (the risk of unpredictable events, from terrorist attacks to natural disasters) 10. Market risk (the risk of price changes in the market, caused by such things as shifts in supply and demand) What Risk Should You Take? The secret to successful investing is that some risks are easier for you to take than others. Let s go back to the bank example for a moment. 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 9

11 If you put your money in a time deposit, what is the new risk you are taking that causes them to pay you more? The risk is called liquidity risk. It means you might need your money before the term of the deposit is completed and either not be able to get it or have to pay a penalty for early withdrawal. Now my question is simply this: Do you care? I mean, really, if I can double your return and all you have to do is guarantee that you don t need to touch the money for six months, is that a good deal for you? For most individual investors, especially young people, the answer is a resounding I don t care. Just give me the return! long. In that case you should be taking liquidity risk all day 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 10

12 What about volatility risk? If I can double your return, but it means that on some days we are going to be way down and other days way up, do you care? Once again, most individual investors do not care very much about volatility. So long as they don t have to take a long-term risk of capital loss, they would be perfectly happy for the price to fluctuate on a daily basis if it means a better return for them over the long term. In that case, you should be taking liquidity risk and volatility risk all day long. This is risk is emotionally inexpensive for you to take. There are investors that can t do this. Think of a publicly traded company. If they make a large investment and the price is down on the day they close their books (end of their 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 11

13 fiscal year), they have to report the loss to their shareholders. Everyone involved then loses their jobs! To them, volatility risk is unacceptable. Thus, individual investors tend to enjoy a competitive advantage in taking liquidity risk when compared with institutional or corporate investors. The First Golden Key to Successful Investing is to find a risk where you enjoy a competitive advantage and to take as much of that risk as possible! You will not find this in any other book. thing! Everyone keeps talking about risk as if it were one This investment is too risky! 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 12

14 Everyone keeps talking about risk as if it affected everyone the same. The risk-return profile of this is favorable to investors. It s not. And it doesn t. Risk is many things, and it affects everyone differently! The real problem is that financial institutions and large institutional investors are ruining the game for everyone. They tell hedge funds to develop products with daily liquidity and low volatility! I guarantee there is no way to generate a return. If you want daily liquidity and low volatility, get a bank account. 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 13

15 With monthly liquidity (you can only redeem at the end of the month) on a well-managed portfolio of hedge funds, you might get 8 percent to 12 percent per year. With semiannual liquidity (you can only redeem every six months), your returns would be more like 15 percent to 20 percent per year. If you don t care about liquidity risk, then this is a great deal for you! It is useful to point out that different risks are rewarded differently in the market at different times. At the time I am writing, the market is rewarding liquidity risk very highly. The reason is all the big investors can t take this risk. This is a golden opportunity for small private investors. 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 14

16 After all, private equity (new companies that are not traded on any public exchange), large construction projects, certain hedge-fund investment strategies, real estate, etc., all require a certain amount of time for completion or for resale of the assets. Somebody has to take the risk, and the market is willing to pay a premium to those who do! Never make an investment without knowing the risk you are being asked to take. If someone tells you there is no risk, they are either ignorant or fraudulent. Either they don t know what they are talking about or they are lying through their teeth! Run away as fast as possible. You get paid to take risk. Find out what you are getting paid for. 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 15

17 You Are Basically in the Insurance Business Since the only thing you can get paid for in the investment game is taking risk, you are basically now in the insurance business. Here are some questions you should ask yourself in making any investment: Question: What is the risk (undesirable event) that I am being asked to insure? Question: Do I have a competitive advantage in taking that risk? Question: Is there an inexpensive way to reduce that risk? Every insurance company specializes in taking certain types of risk. If they have to insure a type of risk where they do not enjoy a competitive advantage, they reinsure that risk with another insurance company! 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 16

18 You can do the same thing. Look at the investment. occur? What are the risks? What undesirable events could Which of those do you want to get paid for insuring? Which of them do you want to pay someone else to take over for you? For example, suppose you have purchased a piece of investment real estate. What are the risks? 1. The housing market could dry up, and the price of the property could fall (market risk) 2. The house could burn down (event risk) 3. The furnishings could be stolen (event risk) 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 17

19 4. The neighbor s child could fall in the pool, and you could be sued for everything that you own (event/regulatory risk) Which of these risks do you want to take? Don t say, None of them! You will never get paid. Say, for example, that you have thoroughly studied the housing market. You like the demographics. Population and income are increasing. There are plans to build a new factory in the area, creating more jobs. You like the market risk. Still you don t want to put 100 percent of your capital at risk. What do you do? 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 18

20 You take out a non-recourse loan with the bank for 80 percent of the value of the property. Now, the event risk you don t like at all. Why? You don t know anything about it. You don t know what the odds are on this particular gamble, and if something goes wrong, you face catastrophic losses. What do you do? You take out fire and theft insurance, and wrap the property in a corporate structure that protects the rest of your assets should any of these unforeseen events take place. That is called being a professional investor. There are many ways you can reinsure your investments: 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 19

21 1. Fire, theft, and liability insurance 2. Key man insurance 3. Use of corporate vehicles to isolate risk to a single investment 4. Use of non-recourse loans 5. Title insurance 6. Options 7. CPPI and other capital guarantee structures on investment funds 8. Stop losses on stock trading transactions The more of these tools that you understand and know how to use, the better an investor you become! Once again, in every investment, think of yourself as an insurance company. What are the undesirable events that you are being asked to insure against? Do you have a competitive advantage in insuring those events? 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 20

22 Which risks would you like to reinsure, and how can you do that in a cost-efficient manner? The Second Golden Key: Returns Once again, in investing you are paid to take risk. In the investing world, the payment you receive for taking risk is called the return. Return is simply the possibility of good things happening to you. In other words: The return that you get for accepting the possibility that bad things may happen to you is the possibility that good things may happen to you as well. These returns come in three different forms. 1. Fixed returns (returns that are guaranteed in a fixed amount) 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 21

23 2. Variable returns (returns that change depending on circumstances and performance) 3. Opportunity returns (returns that depend on certain events or conditions) Question: What return am I being offered in exchange for the risk that I have to take? Question: Are those returns fixed, variable, or opportunity returns? Question: Does the value of those returns outweigh the risks that I am unable to reinsure? Question: How can I increase those returns by taking more risk in those areas of risk where I feel most comfortable? Now what you have to do is actually write the insurance policy! Sit down and spell out clearly the undesirable results you are being asked to insure, which of those results you 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 22

24 can effectively reinsure and how you will do that, and the reward or return that you are being offered or believe that you can receive in exchange for taking that risk. This is a very simple process, but how many investors do it? How many discipline themselves to do this one simple thing? This would save more money on Wall Street than all of the stock advice and newsletters that have ever been written. The Second Golden Key to Successful Investing is to write the policy! What are the undesirable events that I am taking responsibility for? Which of those can I reinsure, and how will I do that? What return am I being promised or anticipating in exchange for taking that risk? What is the policy you are being asked to write? 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 23

25 Write the policy! Increasing Returns Through Leverage Leverage simply means borrowing money to invest with. Leverage is one way to increase the risk of an investment, and thus accelerate the return you can get on an investment. Let s walk through an example. Say you are going to purchase a stock. The stock now trades at $50 per share, and you have $5,000 to invest. You can purchase 100 shares. If the value increases to $60 per share in one month, you will make $10 per share, or $1,000. What happens if you use leverage? 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 24

26 You get your broker to loan you $2,500. Now you have $7,500 to invest. You can purchase 150 shares. If the value increases to $60 in one month, you sell your 150 shares for $9,000. You pay back the $2,500 you borrowed, leaving you with $6,500. Instead of $1,000, you have made $1,500 minus the interest your broker charges you for using the money. The most effective use of leverage is to increase the volatility of a nonvolatile asset or to decrease the volatility of a volatile asset. If you want to make an asset more volatile so that it produces returns faster, then you can borrow money to increase the size of your investment. If you want to make an asset less volatile so that you control risk more effectively, then you de-leverage. What this means is you put a portion of your money into cash, 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 25

27 government bonds, or other low-volatility investments to lower the volatility of your overall position. Billionaires actually pay banks to do this for them. They choose an investment and tell the bank exactly what volatility they wish to hold that asset at. The bank then leverages or de-leverages the investment every month to keep the volatility at the pre-agreed level. That is some very sophisticated investing, but the concept is simple. If you want to accelerate returns, leverage up. If you want to reduce risk, leverage down. Now there is just one more concept you need to understand to fully master the concepts of investing and risk. 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 26

28 The Third Golden Key: Arbitrage Ultimately all investments are based on the idea of arbitrage. Arbitrage is what happens when two people or markets value the same thing differently at the same time. Say that crude oil is selling for $58 per barrel in New York, and at the same time it is selling for $60 in London. This is a golden opportunity for arbitrage. You buy the oil in New York at the same time you sell it in London. This has traditionally been the area where hedge funds have made the most money. People value different things in different ways at different times. 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 27

29 This is actually the foundation of all economic transactions. The seller of goods values the cash more than the goods and the buyer of goods values the goods more than the cash. We can do business! Arbitrage opportunities may occur due to differences in time, place, regulation, liquidity, crises, panicked markets, situations where the market is valuing companies based on their revenue rather than on their underlying assets, differences in regulation, or many other factors. Fundamentally, the less efficient a market is, the more opportunities there will be for arbitrage. Consider the situation of a distressed real estate sale. The owner of a building worth $2 million finds his business in trouble and needs $1 million in cash within 24 hours to save his company. 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 28

30 There are very few places that can get you that kind of cash on that schedule, and most of them will take your kneecaps and your children as collateral. Real estate markets are pretty inefficient and illiquid as markets go. You say to the owner of the real estate, Sure, I can get you your $1 million; I just want the building. He replies, But the building is worth $2 million. You simply say, Six months from now it is worth $2 million; today it is worth $1 million. Arbitrage! There is a difference in perception of values caused by the liquidity crises in his business. Now, every investment transaction you ever enter into will be a case of arbitrage. 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 29

31 If two people do not value the transaction differently, it cannot take place. The questions you need to ask yourself are these: Question: Do I have a valid reason for believing the value to be different than the price I am being asked to pay? Question: Do I have a valid reason for believing the value will change in the future? Question: Is there something unique about me or my situation that allows me to value this opportunity or risk differently? Arbitrage comes in two forms: Risk arbitrage and price arbitrage. 1. You believe either that the investment is fundamentally worth more than the price you must pay or that the value will increase in the 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 30

32 future due to factors that the seller is not properly valuing. 2. You believe that the risk you are being asked to take on is being valued incorrectly or that you enjoy a unique competitive advantage in taking on this form of risk. One of my favorite arbitrage stories involves a company CEO who realized one day that his company was going to go bankrupt. They were almost out of money, and in seven days they would fail to meet their payroll obligations. The CEO took all of the company s money out of the bank and went to Las Vegas. He sat down in front of the roulette wheel and put all the money on red. Now when you bet in roulette, what is the risk that you take? 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 31

33 money. If the ball lands on another color, you lose all your The return that you get is the opportunity that if it comes up red, you will double your money. This CEO understood investing very well. He had a unique competitive advantage in taking loss of capital risk. After all, in one week he had a 100 percent chance of losing all his capital anyway! Brilliant arbitrage! Three rolls of the roulette wheel later, he saved his company. The Third Golden Key to Successful Investing is to use the principle of arbitrage. If you are able to value the price or the risk of an investment differently and more accurately than others, you will make money in investing. 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 32

34 Summary The Three Golden Keys to Successful Investing 1. Find a risk where you enjoy a competitive advantage and take as much of that risk as possible. 2. Actually write the insurance policy before investing. 3. Make effective use of arbitrage. Know the value of things. The Seven Steps of the Investment Process 1. Understand the risk you are being asked to underwrite. 2. Identify those risk areas where you enjoy a competitive advantage. 3. Take as much of that risk as possible. 4. Reinsure everything else. 5. Look for arbitrage opportunities where pricing in the market is inefficient (inefficient markets), or where you have a good reason to believe 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 33

35 values will change in the future (uninformed markets). 6. Become an expert in identifying what things are worth. 7. Use leverage as a tool to control volatility (the speed at which your investments produce an economically meaningful return). We wish you all the best in your investing endeavors. May the market winds blow in your favor, and may all your losses be the ones you reinsured. James Skinner, Roice Krueger, Mark Victor Hansen 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 34