THREE GOLDEN KEYS OF SUCCESSFUL INVESTING Three Golden Keys of S… · The Three Golden Keys of...

TheTHREE GOLDEN KEYS OF

SUCCESSFULINVESTING

What the World’s Best Investors Know and Aren’t Telling

© 2007, James Skinner, Roice Krueger, and Mark Victor Hansen, All rights reserved. 1

Ideas That Can Change Your Life™ in Wealth

The Three Golden Keys of

Successful Investing What the World’s Best Investors Know and Aren’t

Telling

James Skinner, Roice Krueger, and Mark Victor Hansen

“The Three Golden Keys of Successful Investing”

will tell you what professional investors know and

what amateurs learn the hard way!

___________________________________________



The Three Golden Keys of Successful Investing

The Authors

JAMES SKINNER is the founder of two global financial

groups that manage billions of dollars of assets. He is

also recognized as one of the world’s foremost business

thinkers and appears regularly on Japanese television.

ROICE KRUEGER co-founded Franklin Covey, the

world’s largest training company, and has supervised

consulting projects for 80 percent of the Fortune 500.

MARK VICTOR HANSEN is the co-creator of the Chicken

Soup for the Soul empire and is the best-selling nonfiction

author of all time. His goal is to make the planet work

for all humanity!

NOTE: Ideas That Can Change Your Life™ is a

collaboration of three of the world’s most amazing

authors, speakers, and thinkers. The first person “I” may

refer to any of the authors.




Foreword

There is no foreword to this book.

The markets don’t have time for that! Neither do

we. Let’s get right into it!

James Skinner, Roice Krueger, Mark Victor Hansen




The First Golden Key: Risk

The only thing you ever get paid for in investing is risk.

You are paid to take a risk that somebody else does

not want to take. That is the only game in town.

Risk is merely the possibility of an undesirable event

occurring.

People are willing to pay you to take on the

possibility of an undesirable event happening to you,

rather than holding on to the possibility of that

undesirable event happening to them!

When you put money in the bank, is there a risk?

Yes, there is a risk.

How do you know?

Because they pay you for doing it!




It really is that simple. If you get paid, you are

getting paid because there is a risk.

If there were no risk, you would have to pay them

for safekeeping your money.

So what is the undesirable event that could happen?

The bank could go bankrupt and not be able to pay

you back. A lot of banks could go bankrupt on the same

day, and the government could default on its obligation

to insure your deposits.

Now the likelihood of that happening seems small,

so the return you get on your investment is also small!

Now you know why you don’t get much interest on

your savings account.

If you put your money into a time deposit at the

same bank, is there more risk?

Yes!




How do you know?

Because they pay you more!

It really is that simple.

Bankers are brilliant. After all, they have been doing

this risk thing for thousands of years and have learned a

thing or two about it along the way.

You deposit your money in the bank. The bank then

loans that money to somebody else. They charge that

person one interest rate and give you another. The

difference is theirs to keep.

Savings deposit: Pay 2.5 percent interest

Loan: Charge 7.5 percent interest

Bank’s profit: 5 percent of your money every single

year!




The bank doesn’t want to risk loaning out its own

money, so it pays you to take the risk. It loans out your

money instead!

Now banks are really clever. They get the

government to insure the deposits, which reduces your

risk, and thus reduces the amount of money they have

to pay you for your deposits.

Basically, the taxpayer subsidizes the bank! The

taxpayer pays for most of the risk, so that the bank can

loan out money at a profit.

No wonder banks always have the biggest and best

buildings on all the prime real estate in every city in the

country!

Don’t Minimize Your Risk!

Most investors are taught that when you invest, you

should minimize your risk. This is stupid! If you

minimize your risk, you minimize your return! Get it?




Risk Is Not One Thing

Everybody keeps talking about risk as if it is one thing.

It’s not.

Once again, risk is merely the possibility of

undesirable events occurring.

Since many undesirable events are possible in our

lives, risk is not one thing; it is many things.

In investing, we look at many types of risk, which is

just another way of saying that there are different things

that can go wrong with an investment:

1. Capital risk (risk of losing your money)

2. Volatility risk (risk that the price will go up and

down)

3. Liquidity risk (the risk that you can’t get to your

money when you need it)

4. Credit risk (the risk of a counterparty going

bankrupt)

5. Regulatory risk (the risk that laws, regulations,

and tax rules may change)




6. Currency risk (the risk that the currency that

your investment is in—$, \, €—may change in value)

7. Country risk (the risk that the country you are

invested in may become unstable: war, change of

government, etc.)

8. Reputation risk (the risk that your reputation will

be ruined by associating yourself with a

particular investment

9. Event risk (the risk of unpredictable events,

from terrorist attacks to natural disasters)

10. Market risk (the risk of price changes in the

market, caused by such things as shifts in supply

and demand)

What Risk Should You Take?

The secret to successful investing is that some risks are

easier for you to take than others.

Let’s go back to the bank example for a moment.




If you put your money in a time deposit, what is the

new risk you are taking that causes them to pay you

more?

The risk is called “liquidity risk.” It means you might

need your money before the term of the deposit is

completed and either not be able to get it or have to pay

a penalty for early withdrawal.

Now my question is simply this:

Do you care?

I mean, really, if I can double your return and all you

have to do is guarantee that you don’t need to touch the

money for six months, is that a good deal for you?

For most individual investors, especially young

people, the answer is a resounding “I don’t care. Just

give me the return!”

In that case you should be taking liquidity risk all day

long.




What about “volatility risk?”

If I can double your return, but it means that on

some days we are going to be way down and other days

way up, do you care?

Once again, most individual investors do not care

very much about volatility. So long as they don’t have to

take a long-term risk of capital loss, they would be

perfectly happy for the price to fluctuate on a daily basis

if it means a better return for them over the long term.

In that case, you should be taking liquidity risk and

volatility risk all day long. This is risk is emotionally

inexpensive for you to take.

There are investors that can’t do this.

Think of a publicly traded company.

If they make a large investment and the price is

down on the day they close their books (end of their




fiscal year), they have to report the loss to their

shareholders.

Everyone involved then loses their jobs!

To them, volatility risk is unacceptable.

Thus, individual investors tend to enjoy a

competitive advantage in taking liquidity risk when

compared with institutional or corporate investors.

The First Golden Key to Successful Investing is to

find a risk where you enjoy a competitive advantage

and to take as much of that risk as possible!

You will not find this in any other book.

Everyone keeps talking about risk as if it were one

thing!

“This investment is too risky!”




Everyone keeps talking about risk as if it affected

everyone the same.

“The risk-return profile of this is favorable to investors.”

It’s not. And it doesn’t.

Risk is many things, and it affects everyone

differently!

The real problem is that financial institutions and

large institutional investors are ruining the game for

everyone.

They tell hedge funds to develop products with daily

liquidity and low volatility!

I guarantee there is no way to generate a return.

If you want daily liquidity and low volatility, get a

bank account.




With monthly liquidity (you can only redeem at the

end of the month) on a well-managed portfolio of hedge

funds, you might get 8 percent to 12 percent per year.

With semiannual liquidity (you can only redeem

every six months), your returns would be more like 15

percent to 20 percent per year.

If you don’t care about liquidity risk, then this is a

great deal for you!

It is useful to point out that different risks are

rewarded differently in the market at different times.

At the time I am writing, the market is rewarding

liquidity risk very highly.

The reason is all the big investors can’t take this risk.

This is a golden opportunity for small private

investors.




After all, private equity (new companies that are not

traded on any public exchange), large construction

projects, certain hedge-fund investment strategies, real

estate, etc., all require a certain amount of time for

completion or for resale of the assets. Somebody has to

take the risk, and the market is willing to pay a premium

to those who do!

Never make an investment without knowing the risk

you are being asked to take.

If someone tells you there is no risk, they are either

ignorant or fraudulent. Either they don’t know what

they are talking about or they are lying through their

teeth!

Run away as fast as possible.

You get paid to take risk.

Find out what you are getting paid for.




You Are Basically in the Insurance Business

Since the only thing you can get paid for in the

investment game is taking risk, you are basically now in

the insurance business.

Here are some questions you should ask yourself in

making any investment:

Question: What is the risk (undesirable event) that I

am being asked to insure?

Question: Do I have a competitive advantage in

taking that risk?

Question: Is there an inexpensive way to reduce

that risk?

Every insurance company specializes in taking

certain types of risk.

If they have to insure a type of risk where they do

not enjoy a competitive advantage, they reinsure that

risk with another insurance company!




You can do the same thing.

Look at the investment.

What are the risks? What undesirable events could

occur?

Which of those do you want to get paid for

insuring?

Which of them do you want to pay someone else to

take over for you?

For example, suppose you have purchased a piece of

investment real estate.

What are the risks?

1. The housing market could dry up, and the price

of the property could fall (market risk)

2. The house could burn down (event risk)

3. The furnishings could be stolen (event risk)




4. The neighbor’s child could fall in the pool, and

you could be sued for everything that you own

(event/regulatory risk)

Which of these risks do you want to take?

Don’t say, “None of them!”

You will never get paid.

Say, for example, that you have thoroughly studied

the housing market. You like the demographics.

Population and income are increasing. There are plans

to build a new factory in the area, creating more jobs.

You like the market risk.

Still you don’t want to put 100 percent of your

capital at risk.

What do you do?




You take out a non-recourse loan with the bank for

80 percent of the value of the property.

Now, the event risk you don’t like at all.

Why?

You don’t know anything about it. You don’t know

what the odds are on this particular gamble, and if

something goes wrong, you face catastrophic losses.

What do you do?

You take out fire and theft insurance, and wrap the

property in a corporate structure that protects the rest of

your assets should any of these unforeseen events take

place.

That is called being a professional investor.

There are many ways you can reinsure your

investments:




1. Fire, theft, and liability insurance

2. Key man insurance

3. Use of corporate vehicles to isolate risk to a

single investment

4. Use of non-recourse loans

5. Title insurance

6. Options

7. CPPI and other capital guarantee structures on

investment funds

8. Stop losses on stock trading transactions

The more of these tools that you understand and

know how to use, the better an investor you become!

Once again, in every investment, think of yourself as

an insurance company.

What are the undesirable events that you are being

asked to insure against?

Do you have a competitive advantage in insuring

those events?




Which risks would you like to reinsure, and how can

you do that in a cost-efficient manner?

The Second Golden Key: Returns

Once again, in investing you are paid to take risk.

In the investing world, the payment you receive for

taking risk is called the return.

Return is simply the possibility of good things

happening to you.

In other words:

The return that you get for accepting the possibility

that bad things may happen to you is the possibility

that good things may happen to you as well.

These returns come in three different forms.

1. Fixed returns (returns that are guaranteed in a

fixed amount)




2. Variable returns (returns that change depending

on circumstances and performance)

3. Opportunity returns (returns that depend on

certain events or conditions)

Question: What return am I being offered in

exchange for the risk that I have to take?

Question: Are those returns fixed, variable, or

opportunity returns?

Question: Does the value of those returns outweigh

the risks that I am unable to reinsure?

Question: How can I increase those returns by

taking more risk in those areas of risk where I feel most

comfortable?

Now what you have to do is actually write the

insurance policy!

Sit down and spell out clearly the undesirable results

you are being asked to insure, which of those results you




can effectively reinsure and how you will do that, and

the reward or return that you are being offered or

believe that you can receive in exchange for taking that

risk.

This is a very simple process, but how many

investors do it?

How many discipline themselves to do this one

simple thing?

This would save more money on Wall Street than all

of the stock advice and newsletters that have ever been

written.

The Second Golden Key to Successful Investing is

to write the policy! What are the undesirable events

that I am taking responsibility for? Which of those

can I reinsure, and how will I do that? What return

am I being promised or anticipating in exchange

for taking that risk?

What is the policy you are being asked to write?




Write the policy!

Increasing Returns Through Leverage

Leverage simply means borrowing money to invest with.

Leverage is one way to increase the risk of an

investment, and thus accelerate the return you can get

on an investment.

Let’s walk through an example.

Say you are going to purchase a stock.

The stock now trades at $50 per share, and you have

$5,000 to invest.

You can purchase 100 shares.

If the value increases to $60 per share in one month,

you will make $10 per share, or $1,000.

What happens if you use leverage?




You get your broker to loan you $2,500. Now you

have $7,500 to invest.

You can purchase 150 shares.

If the value increases to $60 in one month, you sell

your 150 shares for $9,000. You pay back the $2,500 you

borrowed, leaving you with $6,500. Instead of $1,000,

you have made $1,500 minus the interest your broker

charges you for using the money.

The most effective use of leverage is to increase the

volatility of a nonvolatile asset or to decrease the

volatility of a volatile asset.

If you want to make an asset more volatile so that it

produces returns faster, then you can borrow money to

increase the size of your investment.

If you want to make an asset less volatile so that you

control risk more effectively, then you de-leverage. What

this means is you put a portion of your money into cash,




government bonds, or other low-volatility investments

to lower the volatility of your overall position.

Billionaires actually pay banks to do this for them.

They choose an investment and tell the bank exactly

what volatility they wish to hold that asset at. The bank

then leverages or de-leverages the investment every

month to keep the volatility at the pre-agreed level.

That is some very sophisticated investing, but the

concept is simple.

If you want to accelerate returns, leverage up.

If you want to reduce risk, leverage down.

Now there is just one more concept you need to

understand to fully master the concepts of investing and

risk.




The Third Golden Key: Arbitrage

Ultimately all investments are based on the idea of

“arbitrage.”

Arbitrage is what happens when two people or

markets value the same thing differently at the same

time.

Say that crude oil is selling for $58 per barrel in New

York, and at the same time it is selling for $60 in

London.

This is a golden opportunity for arbitrage.

You buy the oil in New York at the same time you

sell it in London.

This has traditionally been the area where hedge

funds have made the most money.

People value different things in different ways at

different times.




This is actually the foundation of all economic

transactions.

The seller of goods values the cash more than the

goods and the buyer of goods values the goods more

than the cash. We can do business!

Arbitrage opportunities may occur due to

differences in time, place, regulation, liquidity, crises,

panicked markets, situations where the market is valuing

companies based on their revenue rather than on their

underlying assets, differences in regulation, or many

other factors.

Fundamentally, the less efficient a market is, the

more opportunities there will be for arbitrage.

Consider the situation of a distressed real estate sale.

The owner of a building worth $2 million finds his

business in trouble and needs $1 million in cash within

24 hours to save his company.




There are very few places that can get you that kind

of cash on that schedule, and most of them will take

your kneecaps and your children as collateral.

Real estate markets are pretty inefficient and illiquid

as markets go.

You say to the owner of the real estate, “Sure, I can

get you your $1 million; I just want the building.”

He replies, “But the building is worth $2 million.”

You simply say, “Six months from now it is worth

$2 million; today it is worth $1 million.”

Arbitrage!

There is a difference in perception of values caused

by the liquidity crises in his business.

Now, every investment transaction you ever enter

into will be a case of arbitrage.




If two people do not value the transaction

differently, it cannot take place.

The questions you need to ask yourself are these:

Question: Do I have a valid reason for believing the

value to be different than the price I am being asked to

pay?

Question: Do I have a valid reason for believing the

value will change in the future?

Question: Is there something unique about me or

my situation that allows me to value this opportunity or

risk differently?

Arbitrage comes in two forms: Risk arbitrage and

price arbitrage.

1. You believe either that the investment is

fundamentally worth more than the price you

must pay or that the value will increase in the




future due to factors that the seller is not

properly valuing.

2. You believe that the risk you are being asked to

take on is being valued incorrectly or that you

enjoy a unique competitive advantage in taking

on this form of risk.

One of my favorite arbitrage stories involves a

company CEO who realized one day that his company

was going to go bankrupt.

They were almost out of money, and in seven days

they would fail to meet their payroll obligations.

The CEO took all of the company’s money out of

the bank and went to Las Vegas.

He sat down in front of the roulette wheel and put

all the money on red.

Now when you bet in roulette, what is the risk that

you take?




If the ball lands on another color, you lose all your

money.

The return that you get is the opportunity that if it

comes up red, you will double your money.

This CEO understood investing very well. He had a

unique competitive advantage in taking loss of capital

risk.

After all, in one week he had a 100 percent chance

of losing all his capital anyway!

Brilliant arbitrage!

Three rolls of the roulette wheel later, he saved his

company.

The Third Golden Key to Successful Investing is to

use the principle of arbitrage. If you are able to

value the price or the risk of an investment

differently and more accurately than others, you will

make money in investing.




Summary

The Three Golden Keys to Successful Investing

1. Find a risk where you enjoy a competitive

advantage and take as much of that risk as

possible.

2. Actually write the insurance policy before

investing.

3. Make effective use of arbitrage. Know the value

of things.

The Seven Steps of the Investment Process

1. Understand the risk you are being asked to

underwrite.

2. Identify those risk areas where you enjoy a

competitive advantage.

3. Take as much of that risk as possible.

4. Reinsure everything else.

5. Look for arbitrage opportunities where pricing

in the market is inefficient (inefficient markets),

or where you have a good reason to believe




values will change in the future (uninformed

markets).

6. Become an expert in identifying what things are

worth.

7. Use leverage as a tool to control volatility (the

speed at which your investments produce an

economically meaningful return).

We wish you all the best in your investing

endeavors. May the market winds blow in your favor,

and may all your losses be the ones you reinsured.

James Skinner, Roice Krueger, Mark Victor Hansen

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