The Cost of Capital:

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The Most Important Investing Concept You’ll Ever Need to Know

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Most of the commentary we hear about the capital markets these days is based around some type of forecasting. The way it usually goes is, the commentator will say something like: “If Greece does XYZ, then the following five things will happen. Once those five things occur, interest rates/stocks will almost surely drop/rise.”

Forecasting can be fun. But as anyone who has ever tried to predict at the start of the hockey season which two teams were going to end up in the Stanley Cup finals already knows, it’s not particularly useful.

The same holds true for financial forecasts. Even a casual look at the track records of most market forecasters reveals that their predictions are seldom any more accurate than random chance.

To be fair, it’s not entirely their fault. The future is a tough thing to get right. Even the best and brightest of us get it wrong more often than not. The Internet, for example, has changed everything we do. But as little as 25 years ago, no one would have guessed that such a thing was even remotely possible.

So why do we love forecasters so much? Because we all want to get higher returns without taking any risks. It’s only natural. Who wouldn’t want to believe they can grow their money without ever seeing their investments go down in value, just by doing whatever their favourite televised experts tell them to do?

This desire to reap the rewards without the risk is the reason why forecasters and market timers rule the airwaves. Investors want the higher returns that stocks and commodities can offer, but they don’t want to take on the risks associated with them. So to meet this need, the cable news channels bring out their soothsayers and ask them to predict the future.

The idea is, if you can predict the future, you’ll know precisely when to get into a risky asset, and when to get out. You’ll get a great return, without ever having that sinking feeling that comes from seeing your favourite stocks head south.

Sounds great, right? The only problem with forecasting is, it doesn’t work.

Don’t take my word for it. Ask Warren Buffett. The man many have called the greatest investor of our generation has repeatedly said that the short-term movements of the markets are almost completely random, and therefore more or less impossible to predict.

To put it another way: forecasting or timing the market is the same thing as guessing. And guesses aren’t going to secure your retirement.

A more reasonable approach is to recognize that risk and return are intrinsically linked. You can’t have one without the other. The risks can be different, depending on the nature of the investment. But higher returns will always come with greater risk.

As investors, the biggest thing governing your ability to get a higher return is the cost of the capital you want to invest. As the cost of capital goes up, your potential return – and potential risk – go up with it.

To give you an example that most of us are (unfortunately) familiar with, let’s look at the “cost” of taking out a loan. When a huge company like Wal-Mart goes to the bank or the capital markets to get financing, their cost of capital is very low. Why? Because they have a bulletproof balance sheet, a market share that’s unlikely to decrease any time soon, and the ability to pretty much crush any competition that comes their way.

All of this makes for a low-risk situation for the lender (or investor), so they can comfortably “loan” Wal-Mart all the money they want at a very low rate of interest.

The opposite occurs when, say, a junior oil or gas company wants to raise some cash for a little exploratory drilling. Their track record, balance sheet and likelihood of success are all practically non-existent, so nine times out of ten, they can’t even get a loan. If they do find someone willing to loan them the money, it will be at a very high rate of interest – probably 12% or even 15% – because the cost (and potential risk) of loaning them that capital is going to be through the roof.

When individual investors head out into the marketplace with their hard-earned savings, they basically play the role of the bank in our scenario. Like the bank, they can choose to invest their money in something low-risk like Wal-Mart, and probably earn a low rate of return as a result. Or they can invest their money in something that’s riskier, but which also offers the possibility of a higher return.

Investors who attempt to sidestep this inevitable – by, for example, trying to find something that is both completely safe and which offers a high rate of return – do themselves a serious disservice. You can’t place your capital with Wal-Mart and expect to get a junior oil company’s rate of return. If you could, we’d all already be doing it. The more likely explanation is that the supposedly “safe” investment you’re thinking of sinking all your money into actually has a significant amount of risk, but it’s a risk you simply aren’t yet aware of.

Real investors (by which I mean successful, long-term investors) always keep the notion of the cost of capital front and centre when they head out into the woolly world of investing. They know that getting a higher return means taking on more risk. To them, the real question isn’t how to avoid taking risk. It’s how to manage that risk in an informed, balanced and effective manner.

One of the most powerful ways to manage riskier investments is diversification. Going back to our example, that junior resource company is risky because almost anything could come along that might impact their business or even force them to shut their doors – changes in commodity prices, competition from more established players, key staff being poached – you name it.

But suppose you split your investment between 1,000 such companies. The entire sector could still experience a meltdown. But barring a sector-wide catastrophe, diversifying your investment into a thousand companies would at least remove a large part of the risk associated with investing in a single firm. Over time, even if some of those companies performed poorly, you would still benefit from the high rate of return that all the remaining companies have to pay as the cost of “borrowing” your capital.

If you want to get a higher return for your money, you really only have two choices. You can attempt to steer clear of risk altogether by relying on forecasters to tell you when to buy and sell, and hope you happen to choose the one-in-a-million who’s lucky enough to beat the market with his or her random guesses. Or you can recognize that risk and return are inseparable, and focus your time and energy on managing that risk rather than trying to circumvent it.

When you’re ready to make that choice, you’ll stop trying to guess what the future will bring, and start diversifying your investments in a way that will position you to be successful no matter what happens tomorrow. This will let you capture the high cost of capital, without having to depend on someone else’s crystal ball to accurately predict an unknowable future.

Alan MacDonald, an investment advisor with Richardson GMP Limited, helps investors with over $500,000 of assets make smart decisions about money. Alan is the co-author of “The Copperjar System, Your Blueprint for Financial Fitness” available on Amazon.

For more information please visit www.alanmacdonald.ca or email Alan at Alan.Macdonald@RichardsonGMP.com.

All material by Alan MacDonald, Investment Advisor at Richardson GMP Limited. The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.

Richardson GMP Limited, Member Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.

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