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Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Monday, July 20, 2009

High Returns Mean High Risk

Recently, one of our clients told to us about a close friend who claimed to be making a guaranteed 8% return with another advisor. We asked for some details about the high yielding investment. The best we could tell was that the friend had purchased b. Ford has issued bonds recently that yield around 8%.

You might think that the Ford bonds would be a safe investment now that Ford appears to have avoided bankruptcy (unlike GM and Chrysler). Regardless of what you might think, an 8% return of any sort, currently, must be considered a high return.

A basic investing concept you should never forget is that a high return for an investment means high risk. If you think about it, it makes perfect sense. If, for example, you wanted to raise some money through a bond offering, you would try to pay as little interest as possible. If long-term treasury bonds are paying only 4.3%, why would you sell bonds that promise an 8% return? The answer is that the bonds you are selling are perceived to be riskier than the Treasury bond and can’t be sold unless they promise a higher return; in this case, 8%.

Certainly, Ford seems to be doing better than GM and Chrysler, and the 8% bonds may well turn out to be a good investment. Nevertheless, they are still quite risky and a number of scenarios could render them a poor investment. Consider that even though Ford avoided bankruptcy, it currently has somewhere around $30 billion in debt. The national economy and car market are still struggling and it is still quite uncertain how long the recession will last. A terrorist attack, weather disaster, earthquake, Mideast crisis, Korean war breakout, etc., etc. could cause the recession to drag on and on. If that happens, Ford could be in serious trouble. The GM bankruptcy resulted in bondholders being paid only cents on the dollar for their investment.

Regardless of what the investment is, if it pays a much higher rate of return than other similar investment vehicles, you must assume that it is inherently more risky and you need to be sure you understand what those risks are. Don’t just ask the seller of the investment. He or she is biased by the prospect of their commission/fee for making the sale. Do your own research or find an independent knowledgeable third party.


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