Note: A client recently mentioned hearing about an investment that promised a high rate of interest with what he thought was low Risk. Here is a message I sent to our team.

From time to time, clients get frustrated about “Rule #1″ – risk and return are always related. They wonder why we would hold cash. They wonder if there isn’t something better. They read something on the internet or hear someone else tell them that there is “something” that is very attractive.

Usually this “something” involves an instrument or scheme that “regular investors” haven’t considered. It could be a private investment, or a short maturity bond fund or some sort of intermediate financing, etc. The particulars don’t easily come to mind to the client, but the idea that someone said there is something better rings clearly like a bell.

Very often, these “opportunities” occur in schemes where interest will be paid. Interest payments seem to capture our imagination—regular payments where the returns seem to be easily calculated. I would suggest that Rule #1 still holds and that a good corollary is when this relationship is not simple to see, the risks are still there, and they are more dangerous.

Interest payments accrue to lenders. When you put your money in something that pays interest, you are a lender. Lenders should expect to receive the rewards of a lender, that is, interest payments and a repayment of the amount that was lent.

This is different from what an owner receives. One example of being an owner is investing in stocks. An owner has no promise of repayment, let alone payments for the use of their capital invested. Yet, they invest with the hope that they will get a greater reward than a lender.

Rule #1 Says You May Be Speculating

Here’s the rub—when someone offers you some scheme where the expectation is that your reward is greater that what you would expect to receive as a stock owner, and they package this as interest—this is not lending. It is a speculation. Why? Because it is obvious that the borrower would want to borrow at a cheaper, normal rate. For some reason, they cannot. There is a greater risk that you will not receive regular interest payments, let alone the timely return of your principal.

The borrower’s problem is, how can I borrow to get what I want? The regular lender said “no.” But, if their borrowing can be packaged into an instrument to sell to others, (perhaps retail clients), their wishes might be realized.

This is not uncommon. We saw this in the run-up to 2008 when sophisticated firms put packages of these together with insurance and sold mortgages to lots of people and other institutions. In many cases, these were rated AAA. (It’s worth noting that these created a lot of fee income from the packaging institutions and these fees were added to the cost of the deals—which also reduced returns).

When the crunch came, many of these schemes failed. Why? Because of Rule #1. Suddenly the lender became an owner, but an owner of a subdivided interest in any number of bankrupt properties.

It’s hard to talk people out of their dreams but imagining that Rule #1 isn’t a universal rule is a fantasy. I would say that we should tell people that when lenders try to get the types of returns that owners/stockholders get, it’s pretty much certain that there is large risk involved. As their advisor, we don’t recommend that they pursue this. In the end, however, we recognize that they can do what they’d like.

Finally, I should note that I believe the converse of Rule #1 is not always true: that accepting more risk brings more return. There are a lot of stupid risks, like not wearing your seatbelt, or buying a financial instrument you don’t understand, where you shouldn’t expect a higher return. It is this last example that I worry about with these lending schemes.

Eric Ball, CFA
Chief Executive Officer
America First Investment Advisors, LLC
Omaha, Nebraska

This post expresses the views of the author as of the date of publication. America First Investment Advisors has no obligation to update the information in it. Be aware that past performance is no indication of future performance, and that wherever there is the potential for profit there is also the possibility of loss.