What has cricket, a patent for a new type of cigarette, and a fat lady asleep on a couch got in common? Well, according to the newspapers, they’re all investments. Stay with me here … 

• Fat lady makes a splash … Last year a painting of a huge naked lady asleep on a couch by British painter Lucian Freud, sold for $35m. The Age quotes (15/5/07) its resident art critic: “If there was ever any doubt that art was a great investment, it has been blown out of the water.”
• Investors fuming … The promise of huge returns from a new invention, a self-lighting cigarette, has left investors out of pocket. The Courier Mail reports (11/7/08) that George Carras duped 32 investors out of over $350,000 in an outrageous con about a patent that doesn’t exist.
• Howzat feel … Some 140 investors have lost more than $15m courtesy of failed property development projects conducted by former cricketer, Craig McDermott. The Australian Financial Review (19/7/08) states that at one stage he had 9 developments underway at once, variously promising returns between 12.5% to 20% per annum.

There is something going on here with each of these stories. And the list of failed “investments” is growing … names like Westpoint, Opus, Fincorp, Basis Capital, ACR are painful memories. Investors are still scratching their heads wondering what went wrong.

Former Macquarie Bank CEO, Bill Moss, puts it this way:

“The risk/return distortion was a function of too many people having too much money to invest, which led investors to look further afield for opportunities in alternative assets – which typically did not provide a return commensurate with the investment’s level of risk.”1

Bill sees a big future in bankruptcies, evidently, as he has come out of retirement since leaving Macquarie to head up the PPB Group, specialists in insolvency.

Michael Rice, director of Rice Warner Actuaries, also feels that poorly understood instruments and promises of returns that are literally too good to be true are the usual suspects behind investments turning bad. “If ratings agencies can give AAA ratings to junk, it is clear that you cannot rely entirely on research. There are plenty of products that have failed despite having received favourable reports from research agencies.”2

So when faced by an investment, what risks are worth taking?

The answer is the ones that bear reward. Anything that doesn’t have a reasonable reward is a pointless risk. One of the examples of a pointless risk is “credit risk” in the fixed interest markets.

Apart from basic, garden variety listed bonds, many of the popularly promoted fixed interest investments are quite illiquid, complex, and lacking in market transparency.  This includes a lot of hybrid securities, a lot of derivatives (especially ones packaged up by institutions into "structured products"), mortgages, debentures, various forms of commercial paper traded on “grey markets” and anything known by a pithy acronym.

Failed investments like Fincorp, ACR, Westpoint, Lift Capital, and so on are clear instances of unrewarded risk. Whereas investors were offered, say, 9%, a more appropriate reward for the risks they didn’t know they were taking would be more like 30%.

There simply is no evidence that this stuff actually has a long term positive payoff over and above ho-hum fixed interest securities issued by governments and corporations with high credit ratings.  Sure, junk bonds may have a higher yield during a bull market, but as we've seen recently the premium during good times just doesn't compensate for the slaughter during bad times.

Risk and reward: they’re two ends of the same stick. Insist on scientific evidence before making any investment decision.  Anything that doesn't come with significant evidence of a return premium for its risk should be chucked. 

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