Back to Basics: Six Questions to Consider Before Investing

Written November 9th, 2010

GMO just published a new paper titled “Back to Basics: Six Questions to Consider Before Investing” with the idea that there are six questions to ask before investing in a particular asset class, although the framework can be used on a smaller level as well.

Here are the six questions:

Would investors rationally buy this asset if they did not believe it would give returns above cash?

If investors would buy the asset in the absence of a risk premium, we cannot be confident that there should be one long term.

Where do the returns from this asset come from, and who funds them?

We need to understand the sources of return to properly analyze historical return data and we need to understand what entities are funding the return to give insight into their motivations.

Why would the funder of returns for this asset be willing to offer a return greater than cash in the long run?

If there is no good reason for the entities funding the returns of an asset to be willing to fund a return above cash, the sustainability of a risk premium is questionable.

In trying to understand the analysis, we have an additional set of three questions to consider.

Have the historical returns been consistent with the risk premium we expected?

If we thought there should be a risk premium and there wasn’t or vice versa, perhaps we have missed something important about the asset class.

Have the sources of the returns been consistent with the returns achieved?

If we cannot fully explain where the returns have come from in an asset, we have defi nitely missed an important factor.

Has something important changed to make us doubt the relevance of the historical returns?

The existence of a historical risk premium for an asset and an understanding of where it came from are nice, but if something important has changed about those buying the asset, those funding the returns of the asset, or the characteristics of the asset itself, history may not be all that relevant.

Good framework to start the conversation. The author, Ben Inker, then goes on to look at equities, bonds, commodities, PE, VC, and volatility. For me, the discussion of commodities was particularly interesting as Inker outlines the cost of the roll, the challenge of finding sellers in a rising market, etc.

For the full article, click here.