The first point I want to make, and one that is consistently misunderstood, is that return comes with risk.
The first step is to break down the “market” into asset classes. Broadly, there are three asset classes:
- Equities (aka shares or stocks): these represent a small piece of the ownership of the company. If you buy one share of a company with a million shares, you own 0.0001% of that company. You can vote on decisions, management often ask shareholders to opine on certain items, and you have a right to a proportional piece of the excess profits the company pays to its owners: the dividends.
- Bonds (aka debt or notes): these represent debts of a company or of a government. Most investors own a share of a pool of debt instruments via funds. Very few retail investors would buy bonds directly. The advantage here, is that bonds pay a fixed (or floating, but most retail bonds will be fixed) interest rate (also called a “coupon”). While this sounds superficially similar to dividends on the equities I mentioned above, dividends are paid from profits, if the company doesn’t make a profit, you don’t get a dividend! In contrast coupon payments are fixed, if the company doesn’t pay them, there are various serious consequences that any company would seek to avoid unless they are in the direst of financial straits!
- Alternatives: this represents everything else! Alternatives is a very broad tent and has traditionally included real estate, gold and commodities (raw materials). It now includes private markets (such as private equity) where investments are traded outside exchanges and newer investment classes such as bitcoin. It also includes some fairly funky things like investment grade fine wines and collectables!
Right, so now you have an idea of the three classes from a general level – let’s have a look at what they mean in practice.
The best way to look at any financial asset is in terms of two primary characteristics: risk and reward. Like we discussed about in the Art’s Golden Rules post, there’s no such thing as a free lunch. Much like life, the things that are worth having require work. We’re not owed a great job, a satisfying relationship, skill at a musical instrument. Each of these things require work. Luck may play a part, but by applying your attention and effort in a structured way, you can take control of your destiny and make your own luck.
As we look at each of the asset classes again, we’re going to look at two primary numbers for each: average returns, (making money) and the Standard Deviation of those returns (how much they swing around from year to year). An easy way to think of Standard Deviation is like a band around the number you’re looking at. So, if I tell you an asset has a return of 6% and a standard deviation of 3%, that would mean you’d expect to receive between 3%-9% (in a bad year 6% – 3%, in a good year 6% plus 3%) the majority (~67% of) the time. First off though, let’s look the relationship between risk and return.
The ideal asset (and why it doesn’t exist)
In an ideal world, I’d be able to suggest an asset that makes a massive 15% return each year and barely fluctuates (+/- 1% per year for example), sadly, no such asset exists! The reason it doesn’t exist is that if it did, you’d buy it, right? Of course! Everyone would. And if everyone is buying it, it gets more expensive. If it gets more expensive, then the amount of the underlying thing you’re buying (chunk of debt, piece of the company, barrel of oil) you’re getting for your money is reducing. This is alright as long as you already own the asset and other people are buying it up, because they’ll keep pushing up the price. But don’t be fooled, that doesn’t mean that the true worth of what you own is increasing there are always two values to anything: what something is actually worth (its fundamental value) and what people will pay for it (its price). These are often confused. Sometimes, people even come to believe that the fundamental value is the price, they believe that because I’ll buy it from you now for $1,000, its actually worth that and always will be.
Don’t be one of those people!
The Price Trap
I remember, as a child, being offered £50 for a shiny Charizard at the height of the Pokémon card craze. An obscene amount of money for a nine-year-old! But I wouldn’t sell, I believed it was worth more! I had no evidence of this, but I was vaguely holding out for a better price, with no idea where that price might come from. A short time later, the craze moved on, any shiny Charizard was worth almost nothing. I confused the fundamental value of the card (very little) with the price (at the time, high) and failed to take advantage. Tragic.
In case you weren’t riveted by my story of poor financial planning in my childhood (though surely you were!), a very good example of this in the financial markets is bitcoin.
Now, bitcoin is theoretically a medium of exchange, in that it’s a type of money and you should be able to buy stuff with it. However, in practice, its use is very limited. You can buy some illegal items on the dark web with it and purchase from a couple of forward-thinking sites on the internet, but broadly, bitcoins fundamental value is very low. However, its price is very much not low! In fact, the price of bitcoin has swung wildly from £300 to £14,000 back to £2,500 and now to £20,000. All within five years. By buying bitcoin you could have made a huge return or a huge loss, all depending on when you bought and sold. A final example is a commodity like oil. Traders can bid it up or down, but over time, all that really matters is i) how much power people are using, miles they’re driving and plastic they’re buying and ii) how much oil is being pumped out the ground. Traders can’t change either of those things.
This is where we come to be kernel of truth we’ve been circling. The less sure the market is of the fundamental value of an asset, the more its price is likely to move.
Let’s look at some examples.
- #1: A short term bond owed to a major western government (e.g. a US treasury).
- Q: How sure are we of the fundamental value?
- A: Very. Major western governments always pays their debts and are the largest and richest countries in the world. Something would have to be seriously wrong for you not to get paid back your original stake and the interest.
- Q: How volatile is the price?
- A: Not at all, estimated at ~+/- 3%.
- Q: So how much do I earn?
- A: Barely anything, you’re taking very little risk, so you get very little reward. Right now, you’d only get paid 0.94% on a 10-year US treasury bond.
- Q: How sure are we of the fundamental value?
- #2: A bond owed to a poorly performing company
- Q: How sure are we of the fundamental value?
- A: A bit, but not very. We know what we’re meant to be getting paid and when, but who knows if the company will still be around by the time it comes to getting paid!
- Q: How volatile is the price?
- Fairly volatile, albeit not crazily so. The standard deviation is estimated at ~+/- 8.4%.
- Q: So how much do I earn?
- A: A very decent return! Since inception the Bloomberg Barclays High Yield Corporate Index has returned around 9%.
- Q: How sure are we of the fundamental value?
- #3: Shares in a large company
- Q: How sure are we of the fundamental value?
- A: That’s a bit complicated. We know the company will probably be there over the medium term (since its large and should be performing decently) but we don’t know how fast it will grow or whether it will pay dividends (which are discretionary, unlike interest). You also get none of the certainty bonds offer around a repayment date or interest rate. Overall, you know its worth something, but there’s quite a lot of uncertainty around exactly how much!
- Q: How volatile is the price?
- Very. The standard deviation of the S&P 500 is a whopping 18.8%!
- Q: So how much do I earn?
- A: A very good return. The average return since inception is 10%.
- Q: How sure are we of the fundamental value?
Hopefully this gives you an idea of the trades off on offer. As you look for more return, you’re also taking on more risk, including risk that the value of your investments goes down. Looking at large stocks for example, the range of returns within one standard deviation is a massive -8.8% to 28.8%!
The last point to note is that one standard deviation only gives you what will happen most of the time. Not all the time. The real range of outcomes is even wider than this. In 2008, the S&P 500 lost 36.6% of its value. Emerging markets lost a massive 52.2%! In contrast, bonds racked up a solid 5.2% return.
The following year however, emerging markets returned a HUGE 78.8%, making the 5.9% return on bonds in the same year seem rather weak in comparison.
Luckily for us, we don’t need to choose just one of these assets. We don’t need to risk it all on stocks, hoping for the highest returns but having to accept the possibility of huge losses. We mix and match between in class and, in so doing, try to get the best of all worlds. The upside of equities, but the downside protection offered by bonds. This process is call portfolio allocation, and is the subject of the next post. See you then reader.