Faith-based investing

No, this isn’t a column about investing based on religious or other moral principles. This is a column about the differences between making investment decisions based on the numbers, and making decisions based on your judgment of the quality of people. You will need to make both types, and it’s important to understand the differences.

The most basic type of investment decisions involves doing some math. These investments involve cash flow that will occur out into the future with some higher or lower degree of confidence. In the case of government bonds, that confidence level is very high. You are virtually certain of receiving your cash on time, in fixed amounts that are determined up front. In the case of a piece of income property, the cash flow that comes from rents is somewhat less certain. Still, you can make a rational and sensible estimate of those cash flows.

The eventual outcome of these types of investments is not dependent on a lot of future decisions made by some other person. The late economist Hyman Minsky defined this class of investments as “hedge” investments, meaning that the cash flows from the investment paid in the future have been calculated as sufficient to properly compensate you for the price you paid. The future returns match up nicely to the present cost and to your expectations. A hedge is defined as a pair of offsetting financial effects. You pay out X, and you are highly certain of receiving back Y. If X and Y match up nicely – meaning that Y equals X plus interest – you have a hedge. You don’t need someone to come along and buy your investment from you. You can just own it forever, and you’ll get paid.

In my view, such investments should form the primary foundation in any long-term portfolio. However, hedge investments don’t provide the highest returns. Bonds can pay disappointingly low yields, and even income property doesn’t always pay terrific returns, after accounting for the cost of managing the property.

As we move away from safe and predictable income investments, we step into the world of speculation. It is not a gradual transition. It happens all at once, the moment we rely on the actions and decisions of other people. The simplest example is stocks. We might buy a stock that pays a dividend, but that dividend is small – around 2 percent. It forms a lousy hedge, since we need more than 2 percent. The only way we’re going to get a decent return from this stock is if someone else buys it from us at a higher price. We have to eventually sell the stock to make any money. We are relying on someone else – Mr. Market – to come along and bail us out. Maybe he will; maybe he won’t.

We therefore buy a stock on faith. Faith that another investor will think it is worth more than we paid for it. While the odds are favorable that will happen, the odds are surely not certain.

We also make faith-based investments any time we hire a money manager. If you own a mutual fund, you have hired a money manager. Contrary to popular notions, a mutual fund is not an investment asset. It is a company that is run by a manager who makes investment decisions with your money. In contrast to analyzing an apartment building investment, you cannot sit down and calculate the earnings and cash flows of a mutual fund – it doesn’t have any of its own. The best you can do is to examine the manager’s track record of past decisions and have faith that he or she will continue to make good decisions going forward.

The same is true of real estate partnerships or private equity funds or hedge funds. All of these types of investments involve you placing your money and trust with someone else, in the hope that person will take good care of you. There is nothing inherently wrong with this. In fact, it is the only path to the higher investment returns that a capitalist economy offers. If you want to move beyond the mundane returns available from cash-flow-oriented hedge investments, you have to have faith. Keep this in mind every time you buy a mutual fund or a stock and take steps to satisfy yourself that you have a high degree of faith that good decisions will be made in your behalf.