The other day, a client called me excited about their new investment opportunity – a private credit fund promising 15% returns. They had invested a significant portion of their net worth, convinced they had found the holy grail of passive income.
“I’m getting 15% passive returns! Isn’t this amazing?”
Let’s find out.
After over a decade as a professional investor, I’ve learned that there’s often a stark difference between perceived returns and reality. Over the years of vetting hundreds of deals and reading the fine print, I’ve found that reality does not always match the shiny pitch deck.
In order to help grasp the whole picture, I’ve developed a framework I call The Return Reality Model.
When evaluating any investment, there are three critical components:
- Perceived Return
- Actual Risk
- Hidden Costs
Let’s compare two real-world examples: a private credit fund yielding 15% versus a municipal bond yielding 8%.
At first glance, the math seems simple. On a $1 million investment, you’re looking at $150,000 versus $80,000 annually. That’s a $70,000 difference – that’s real money. But let’s look deeper.
The Perceived Return is driven by three powerful psychological factors:
– FOMO: Everyone else seems to be getting these returns
– Social Proof: “My friend made a killing in private credit!”
– Recency Bias: Recent success stories make us think it will continue
But here’s what they don’t tell you about the Actual Risk:
Did you know that up to 20% of private syndicated funds never return a single dollar to their investors? And that’s just based on the data we can find – the real number is likely much higher, since these are private investments and have no official reporting structure. Compare that to municipal bonds, where the failure rate is effectively zero (cities get bailed out by the federal government if they default).
Want to get your money out quickly? Good luck. Most private credit funds are illiquid, meaning your capital is locked up for years. Meanwhile, you can sell a municipal bond within 24-48 hours if needed.
Then there are the Hidden Costs. I recently reviewed the investment documents for a fund promising 18% returns. The promoters took: – 20% of profits off the top – 5% annual management fee – Another 20% for their property management company – Plus various other fees buried in the fine print
By the time all these fees were paid, investors needed the underlying assets to generate nearly 50% returns before they saw a dime.
If you have a 20% chance of losing your entire principal in the private credit fund (1 in 5), you need to adjust that 15% return to factor in the potential for loss. Suddenly that “safe” 8% municipal bond doesn’t look so boring.
This is known as a risk-adjusted return, which tells you how much return you’re getting for the level of risk you’re taking. One tool for this is the Sharpe ratio, which measures the excess return you’re receiving over the risk-free rate per unit of volatility. Think of it like a risk/reward scorecard – the higher the score, the better the deal looks on a risk-adjusted basis.
The magic of the Sharpe ratio is that it compares your potential returns to what you could get risk-free (like in Treasury bonds). Then it factors in how volatile or unpredictable those returns might be. A higher Sharpe ratio means you’re being well-compensated for the risk you’re taking. A lower one means you might be better off with a simpler, safer investment.
This is exactly how the wealthiest family offices think about investing. They’re not chasing the highest possible returns – they’re looking for the best risk-adjusted returns. When we take this approach, we often find that “boring” investments with strong Sharpe ratios outperform flashier ones over time.
The unsexy choice is usually the smart one.
This doesn’t mean there’s never a place for higher-risk investments in your portfolio. But there’s a reason the wealthiest families I know fill up their “safety bucket” first. When I analyzed their portfolios, I discovered they weren’t taking nearly as much risk as I thought they were.
The reality is, you could build a $30 million portfolio in completely liquid, lower-risk investments before you ever need to chase higher yields. But that doesn’t feel very sexy, does it?
I know because I learned this lesson the hard way. I spent years chasing returns, convinced I had the Midas touch after my first company’s success. I invested in early-stage tech, fintech, health tech, cryptocurrencies, commodities futures, real estate – you name it. I was just following the old adage that it takes money to make money.
What I didn’t realize was that I was solving for the wrong variable. Instead of optimizing for the highest possible return, I should have been optimizing for risk-adjusted return.
Here’s a framework I use now when evaluating investments:
- Fill your safety bucket first (12 months of living expenses in ultra-liquid assets)
- Build a bridge to freedom (5-7 years of expenses in a strategic mix)
- Only then consider higher-risk investments – and never more than 10-15% of your portfolio
Remember: The only way to lose the game is to get knocked out. Your primary business is likely your best wealth-building tool. Focus on that, and use your investments to create safety rather than trying to hit home runs.
The next time someone pitches you an investment promising outsized returns, ask yourself:
What’s the real risk-adjusted return here? What are the hidden costs?
And most importantly – do I really need to swing for the fences, or am I better off playing it safe?
Often, the boring choice is the smart choice.
Keep it rubber side down,
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