A dinner guest at my home last evening inquired as to whether I invested clients’ money in hedge funds. Their thinking was that institutions like large endowments invest in them, so that must be where the really big money is made.

I explained that large endowment funds invest only a tiny fraction of their money in things like hedge funds; and that the bulk of their money is invested in safe investments in stocks and bonds backed by strong and prosperous businesses.

Lots of times folks equate investing with making money – first and foremost. It’s easy to do. But making money should never be the first priority. I like to think of three pillars of investing, and I think of them in order of priority.

First and foremost: don’t lose money. That is not the same thing as watching your portfolio’s value rise and fall with the natural rhythm of the market. We can watch the value of our own homes rise and fall with the vagaries of supply and demand. But we still have a home in which to live. What we don’t want is to see our home burn to the ground – which is precisely the risk when it comes to hedge funds and similar high-risk investments. Investing and speculating are two very different animals.

Second, don’t take on unnecessary risk. To generate a rate of return that will adequately finance our long-term objectives we cannot completely avoid risk. But risk represents the potential for failing to meet those objectives. Exposure to stocks, for example, creates the potential to achieve objectives. On the flip side, it also creates the potential for failure. Take on enough exposure to the beneficial potential but avoid as much of the risk of failure as you can.

Finally, third try to maximize return at the level of risk that is appropriate for you. This is accomplished through diversification, opportunistic rebalancing, controlling taxes and expenses.  These activities do not impact risk so much as they do return. Two portfolios can contain the same level of risk without generating the same return. An un-diversified portfolio can have the same risk level as a well-diversified one. It just won’t generate as much return. Another way of looking at this is that a targeted rate of return will require more risk the less diversified and higher are the taxes and expenses.   

As with all things in life, it is important that we not lose track of our priorities to the allure of chasing maximum potential return. From the expression on my dinner guest’s face, I fear I may not have aided him in his digestion.

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