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Should I Make This Investment?

I came across an interesting question on the Bogleheads forum and thought I would share my thoughts with you.

An investor asked for opinions on investing in subordinated notes of a local bank. Here are the details:

  • The investment requires a $10,000 minimum.
  • The notes earn 7 percent interest and are held for seven years.
  • The bank is independent and has been in business for more than 100 years.
  • The notes are not FDIC insured.
The investor also had a sister that had invested $40,000 already, and several members of the family had banked there for more than 50 years.

First, unless the security is backed by the full faith and credit of the U.S. government (such as with an FDIC-insured CD), the investor is taking what economists call uncompensated risk, risk that can be diversified away (as there are risks idiosyncratic to the issuer). You're not compensated for taking such risk, because the market doesn't offer risk premiums for risks which can be diversified away.

Next, it's important to ask: "Is the high coupon being offered because the issuer likes you? Isn't it the issuer's job to raise capital at the lowest cost?" Thus, the high coupon must reflect a high degree of risk -- the price the market requires to compensate investors for taking such risks.

Finally, it's likely that the investment is being considered because the investor is familiar with the issuer. Familiarity breeds overconfidence, leading to confusing familiarity with safety. This is a common mistake. You can be almost certain the investor wouldn't have considered these notes without already being familiar with the bank. However, it should be obvious that the note is not any safer if you live down the street from the bank than if you had never heard of it. Thousands of banks have failed that investors were quite familiar with.

It's important to note that the same issues of idiosyncratic/uncompensated risks and confusing the familiar with the safe apply to the purchase of individual stocks, as well as individual debt securities. Buying individual stocks has far more to do with speculation than investing, and thus it's avoided by prudent investors who take only compensated (non-diversifiable) risks by investing in entire asset classes.

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