Why do we invest?
Most people would say that they invest so that their money can make money. That’s totally accurate, but it’s not the full explanation.
The longer explanation is that we invest so that capital can be put to more efficient use.
This is the reason why banks lend, why angel investors invest in startups, and why individuals buy bonds issued by corporations. The investor or bank has excess capital that isn't growing and the company has the ability to leverage that capital into higher growth.
Let’s look at a super simple example of how this can be a net-positive for both sides.
Company XYZ is currently worth $9,000,000 and their business is based on selling a computer program. They have the program and capacity for growth, but they need to bring in more customers. They sell stock in their company, call it 10% of the company. With that $1,000,000 investment, they are able to increase their marketing and double their sales. Now their company is worth $20,000,000.
In this case, the original owners go from owning 100% of a $9,000,000 company to owning 90% of a $20,000,000 company. Their ownership is now worth $18,000,000.
The investors purchase 10% for $1,000,000 and end up owning the same 10%, but it’s now worth $2,000,000.
The end result is that the original owners have a smaller piece of a much larger pie, while the new investors also profit. Win-win.
Cost of Capital
You might be wondering how companies decide to take on outside investment, whether that’s via issuing stock or debt. It’s a complex decision, but the heart of the decision goes back to the expected return versus the cost of capital.
Cost of capital (CoC) is the expense that a company incurs when funding its operations and investments.
An example of CoC is the interest paid on a corporate bond. If a corporation can issue a bond that pays 6% interest, they can borrow money for 6%. The implied part here is that they have to expect their project or investment to have a higher return than 6% to justify the cost of the project.
CoC can get complicated quickly and I’m not a corporate finance expert, so I’m not going any deeper. That said, it’s good to know the concept.
Capital Asset Pricing Model
Cost of Capital can be applied to our own portfolios as well, using a formula called the Capital Asset Pricing Model. I’m going to use some math, but I promise it’s not bad.
The CAPM formula is expressed as:
E(ri) = rf + βi (rm − rf)
Where:
E(ri) is the expected return of the investment.
rf is the risk-free rate. The return on an investment with zero risk, typically represented by government bonds.
βi is the beta of the investment.
rm is the market return, which includes all risky assets.
(rm−rf) is the market risk premium, which represents the additional return expected from holding a risky market portfolio instead of risk-free assets.
So, how does this apply to us as investors? It’s a way to think about risk versus reward. Intuitively, it shows that if we’re going to take more risk, we should expect higher returns. On the other side, we can take no risk and simply take the risk-free rate. The optimal combination of risk and return is different for everyone, which is where Modern Portfolio Theory comes into play. I’ll talk about it more in a minute.
Higher Risk, Higher Reward
I hear this a lot and frankly, I think it’s completely misunderstood. It actually triggers me a bit because it leads folks to think that higher risk automatically leads to higher returns.
That’s the wrong way of thinking about risk and return.
A better way of approaching this is asking the question, do I expect to receive a higher return for the increased risk that I’m taking?
Essentially, you’re asking if you’re being paid to take the extra risk. Am I getting a higher reward for the higher risk?
Here’s an example.
Look at the Powerball. It’s the ultimate example of how most folks visualize a high-risk, high reward investment. When you buy a ticket, you either lose 100% of your money, or you match some or all of the balls and you make a return on your “investment”.
A Powerball ticket costs $2. (I had to look it up, I don’t play the lottery.)
The current jackpot is $62.4 million.
Based on the number of balls you match, you can win between $4 and $1 million.
The odds aren’t in your favor though.
When you break down the expected value of the Powerball ticket, it looks like this.
(The expected value is simply your odds multiplied by the outcome, which are then added to get the total value of the ticket)
As you can see, you’re paying $2 to buy a ticket that has an expected return of $.53. That’s not exactly a great investment. Annualized, it’s a 73.5% loss…on average.
Obviously, I don’t think (many) people look at the lottery as an investment. Instead, I’m using it to illustrate that risk doesn’t drive return.
Price, specifically your purchase price, drives return.
If the lottery suddenly began pricing Powerball tickets lower, say at $.25 per ticket, then it would be worth considering. A $.25 ticket would have an expected average gain of ~72%, if the odds and payouts stayed the same.
Investment Expected Value vs Your Return
Just a quick point, but I think it deserves its own section.
Investments have an expected value that is independent of anything we do. As investors, sometimes we know the expected value with precision, other times we can only estimate. Sometimes we have to look at a range of possible outcomes and essentially handicap the odds of each outcome. In each of these cases, we have no control over the performance of the investment.
For example, look at a US Treasury bond. We know with relative certainty that it will mature on a given day and at a given value.
For individual stocks, we could use 12-month price targets from Morningstar or another firm.
From there, your expected return for each is based on the price at which you buy.
Intuitively, if you expect a stock will be worth $100 in 12 months and you buy it for $75 today, your expected return will be higher than if you bought it for $90.
Preference and utility come into play here too, but I’m not going to get into that today.
The point is that both risk and expected values are independent of anything you do, whereas purchase price is the only determinant of return we have any control over.
Risk
What is risk anyway?
I’ve used the term a lot, but I haven’t really defined it. Frankly, it’s a hard term to define and it’s one that means very different things to different people, depending on the situation.
Most people think of risk as volatility, and that’s accurate. Volatility being how much a stock moves, both up and down.
I break down my approach to risk a bit differently. I think about it on three different levels.
At the highest level, risk is the potential for a client to not have the money they need to retire when they want…or stay retired. This risk is influenced by their portfolio, but ultimately it also includes their spending, what other income sources they might have, and a host of other factors.
The biggest method of lowering this risk is by managing liquidity. I do this by using bonds to protect the income they’ll need for 5-7 years, so that they don’t have to worry about what happens in the market on a daily basis.
Next, portfolio risk. At a technical level, portfolio risk is systemic risk
Bigger picture, I look at portfolio risk as market risk. What’s going on in the market, the economy, and the world that could affect the entire portfolio?
An example of portfolio risk is inflation. Inflation is going to affect the entire portfolio, to some extent.
Portfolio risk is harder to manage, but I manage portfolio risk by first identifying potential issues (like the impact of interest rate hikes), then looking at the probability of that issue occurring and the level of impact it would have on each sector of the market. From there, I weight investments towards sectors that I expect will be less impacted by those events. I’ve written about the potential risks I see in the market at the moment here.
Finally, there’s risk at the level of the individual investment. This is specifically for individual stocks or bonds.
Individual risks include concentration risk, i.e. having 40% of a portfolio in a single stock, business risk, i.e. a company is badly run, credit risk, as in a company could be insolvent, or currency risk, because a specific company is exposed to currency fluctuations because they bring a large amount of earnings into the US from overseas.
At this level, risk can be lowered through diversification. Diversification has the benefit of lowering the individual risks and volatility. I rarely recommend individual companies because frankly, picking winners is nearly impossible. I prefer to lower risk by focusing on risk at the portfolio level, like I mentioned earlier.
Next week, I'm going to talk about where stock prices come from and why it's so dang hard to choose stocks that will outperform.
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