How To Practically Think About Risk and Return | Erik Averill, Brandon Averill, Justin Dyer | AWM Insights #50

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Episode Summary

It’s been another eventful week in the markets with a stronger than expected earnings season, Bitcoin continuing to reach new highs despite China testing their own digital currency called the e-yuan, and a SPAC bonanza.

As mentioned last week, Erik, Brandon and Justin spend the majority of this episode discussing how to think about risk, return and allocating capital over the long-term including a framework of how to practically think about risk and return, how to approach long-term investing like a pro, and why ultimately your outcomes matter more than participating in the latest investment fad.

 

Episode Highlights

  • (2:04) How to practically think about risk and return

  • (2:46) The basic valuation formula

  • (3:57) Valuing uncertainty

  • (6:23) The building blocks of risk

  • (7:19) Equities

  • (9:13) Municipal bonds

  • (12:08) Interest rates impact

  • (16:33) Will we return to normal at some point?

  • (17:13) Resource: Josh Brown, The Reformed Broker

  • (18:24) Engineered risk

  • (19:16) Manager skill

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Erik Averill: LinkedIn

Brandon Averill: LinkedIn

Justin Dyer: LinkedIn

+ Read the Transcript

Erik Averill (00:00): Hey, everyone. Welcome back to another episode of AWM Insights. It's your power three. Two CPWAs, and a CFA. We're Erik, Brandon and Justin. And each week we cover what you need to know to capture the returns you deserve, and invest like a pro.

Erik Averill (00:16): And today we're going to focus on how to think about risk-return, and allocating your capital over the longterm. But before we jump into the details, we want to cover a few things that are keeping our attention in the media. Bitcoin, of course, continues to just go towards new highs. The interesting thing is, as we've seen China testing out their own digital currency. And so, it's just a reminder that while Bitcoin or Ethereum may be the topic of conversation, there's over 3,000 different types of cryptocurrency out there. Meanwhile, Japan, first time since 1990, that they have returned to the levels, takes 30 years to get back to the top.

Erik Averill (01:04): And then, we're also seeing that long-term interest rates have jumped recently, and the SPAC bonanza continues to go crazy. And it's really why we want to talk about risk-return and allocating capital, is because during this environment it can feel like the fundamentals don't matter anymore. And the way in which we've made investments, is it really changing? And we thought it would be really appropriate to dive into how the fundamentals still do matter. How risk and return will always be married together. And really, what is the evidence that you need to know to capture the returns that you deserve?

Erik Averill (01:44): And so, with that, I'm going to go ahead and turn it over to Justin, who is our CFA. This is probably going to be more of our technical shows that we've done, but we think it's of immense value for you as the audience to have the greatest investment experience.

Justin Dyer (02:04): Yeah. And I'll try and not go too nerdy on everyone here. But we'll start with how we practically think about risk and return, which Erik really led with here. And the basic place to start is, "Okay. Well, how do you go about valuing an investment?" Whether it be a bond, or a company, a public stock, or a private equity investment, public debt, or private debt. There's all these different types of investments. But really at the end of the day, the basic valuation formula is taking some level of cash flows in the future. You expect, whatever it may be, X amount of revenue next year, the following year, et cetera, et cetera.

Justin Dyer (02:51): And then, you need to discount every single one of those cash flows that you put into your formula. You need to discount them back to the present value. And that gives you some approximation of what you think the value of that investment is. The inputs can be somewhat subjective to you as the investor. Some people will argue around what should, and shouldn't go into that formula. But the overall math equation is consistent. We are taking future cash flows, we're bringing them back to the present day, and we're coming up with a valuation that we're willing to pay, given those inputs.

Justin Dyer (03:33): The critical variable in that whole equation is what you're using to discount the cash flows back to the present day. And that variable, or discount rate, as we call it, is an approximation of what your expected returns are. Or the given level of risk/uncertainty in an investment.

Justin Dyer (03:57): And so, let's put some practical context around that. If you're highly uncertain around an investment, it should have a higher discount rate. If you're more certain around an investment, it should have a lower discount rate. And we'll unpack what goes into that in a little bit here. But that's really the simple mathematical equation on how you're valuing an investment. And it's tried and true, again, I want to underscore this, throughout public markets, private markets, real estate, et cetera. You're trying to say, "Hey, there's an expected future cash flow from this investment. And I'm going to bring that back to the present and have an approximation of value, given the variables that I have estimated to put into this algebraic equation, basically."

Brandon Averill (04:51): Yeah. And I think it's a great point, Justin. I've had several conversations with clients lately. One, certainly, comes to mind on the question we get, "Okay, what do we expect the market to do? What kind of return can I expect? I got Dave Ramsey out there saying, 'I'm going to get 10, 11%.' I've got other people saying that with all the free money floating around, that my expected returns in the near future should be more muted."

Brandon Averill (05:22): And there's a lot of confusion around that. I think it's pretty well known. You've got people out there that quote the long-term average of the S&P 500. And I think what gets lost is that, unfortunately, life doesn't rule in averages. We don't live in averages. And different market environments create different expected return profiles.

Brandon Averill (05:45): And so, walking them through, and I hope you'll do this for us a little bit, but walking through, "How do we, actually, come up with our expected return, that expected discount rate over time?" It is a function of interest rates and that risk-free rate. And right now we're, actually, seeing negative real rates. And we're seeing the risk-free rate at, effectively, zero. The borrowing, right now, it's free. And so, we have all this money out there that is chasing returns. But what does that, actually, mean for the future? It'd be interesting to hear you touch on that a bit.

Justin Dyer (06:23): Sure. So, let me start with the risk-free rate and the building blocks, as we call it internally, in constructing expected return. So, the risk-free rate is quite simply the closest approximation of an investment in the marketplace that has, literally, no default risk. So, the best way to think about that... Or most common instrument we use is the one month or three month Treasury Bill. The likelihood that the US government is going to go bankrupt and not pay on a one month or three month Treasury Bill, is all but zero. And so, that is used as that initial building block, that risk-free rate. And then, you really just build on it from there.

Justin Dyer (07:12): And you can go both down at the equity side, which we'll touch on, and you can go down the fixed income side as well.

Justin Dyer (07:19): On the fixed income side, you start with the risk-free rate. And you say, "Okay. Well, if I'm going to take some form of additional risk through the form of time," meaning, "I'm going to lock my money up for a longer period of time than one month or three months," depending on which one you're using, "I want a little bit more for my money." So, let's go out all the way to 10 years. If you lock up your money, if you lend your money, or you buy a bond that is going to mature in 10 years, you should expect in the market, generally, will pay you more to lock that money up. So, that's the building block that we call term or time, over and above the risk-free rate on that side of things.

Justin Dyer (08:02): You can also take additional risk in the fixed income markets or the bond markets through credit. The example, there is, "Okay, I'm going to lend money to a Coca-Cola, or UPS, or Apple, versus the federal government." And those companies, as good as they are, don't, necessarily, have the same credit rating as the US government. We're talking all things being equal here. We're not going to get into money printing and things like that. That's, potentially another conversation. But all things being equal, the US government has a higher credit quality than a corporation does. And so, if you lend money, let's, again, all things being equal, say you're looking at a five-year treasury bond, and you're comparing it to a five-year bond that UPS has issued. You would expect to receive a little bit more of a rate of return, or an interest rate from that credit bond, from that UPS, Coca-Cola, whatever, that corporate bond. So, that's what we call, again, credit risk. It's the compensation you should expect for the additional risk of default.

Justin Dyer (09:13): You can also add, within this, in the municipal bond space, there's some nuances to the tax treatment of a bond. So, think about like a California municipal bond, versus something like a Florida municipal bond. But those are the basic building blocks that we deal with within fixed income markets. You start with your risk-free rate, you figure out how long you're locking up your money for. And then, are you taking on additional credit risk? And just to highlight the credit side, again, once more, you'll hear the term, high yield bonds. That's exactly what credit is. If you're going into junk bonds, or high yield bonds, you expect to have a higher rate of return. Because, those companies are on far shakier financial ground, than a very high quality blue-chip type corporate company, again, like UPS or Apple or something like that. They can command a lower interest rate because they're a better investment, arguably.

Brandon Averill (10:16): Yeah. And I think that's really insightful. Because, when I start to think of some of the conversations we're having with clients, a lot of it turns to public versus private. And it's the same equation. It's the same building blocks like you talked about in time on the fixed income or bond side. We talk about a lot of this on, there's an additional building block for illiquidity on the equity side.

Brandon Averill (10:40): So, if I'm going to buy, let's say, a real estate investment in the public markets, versus evaluating an investment in the private markets. I should have a higher expected return for my investment in the private markets. Because there's a premium that is expected there, because I'm locking up my money. And I think that's really interesting to think about. It's also why I think it sometimes is confusing when we have... Equity markets have different rates of return year in and year out. And they have different expected rates of return. But what doesn't change, or what hasn't changed over time, significantly, are those premiums that we expect.

Justin Dyer (11:25): Right.

Brandon Averill (11:25): So, what we should be compensated for investing in the US stock market as a whole, we should expect a 5% premium. Now, that doesn't mean we expect 5% every year. It's that building block that gets added on top. And there's a lot of building blocks that, certainly, go into this. But I would love to hear, Justin, how do we think about, "Well, we're building portfolios for our clients over the long-term." And really the impact of these different building blocks as things change like interest rates. I think that's one of the biggest variables that seems to change, and changes that expected return.

Justin Dyer (12:08): It certainly does. So, we call them building blocks because you can stack these things on top of one another. And so, when markets have rallied like they have, and rates have come down like they have. Brandon, I think it was you who mentioned earlier, looking forward, you can make a pretty compelling argument that rates of return should be lower. And the simple building block analogy is as follows, the risk-free rate of return is effectively zero. As we mentioned right now. The equity risk premium that, generally, exists is around 5%. You're not going to see that year in and year out. You are going to see something around that amount, over the longterm. Again, I want to underscore, we're talking about long-term investing and how these things, generally, show up over the longterm.

Justin Dyer (13:00): But to going back to the building blocks, you have a risk-free rate of zero. You add your equity risk premium on top of that. And you're, basically, only getting the equity risk premium. Because, interest rates are so low in the system, you're not stacking those to... You're stacking the equity risk premium on top of zero. And so, you're just getting the equity risk premium, which is, again, somewhere around 5%. So, if you wanted to put a prediction around equity market returns over the next five to 10 plus years, you could say, "Hey, given where we are today, it might approximate around 5% per year."

Justin Dyer (13:37): And then, on top of that equity risk premium, you can add additional factors. So, Brandon, you mentioned the illiquidities piece. That could increase your expected return over the future if you're locking your capital up in an illiquid type investment, you should expect an additional premium there. If you're in certain areas of the market, what we call factors. Size, which are small companies, they, generally, have a higher expected return than large companies. Value companies, same thing, have a, generally, larger expected return than growth companies. Momentum is a really interesting factor, if you will, but there's some academic research that shows if you participate in that, you should expect a little bit of a higher rate of return. And so, depending on how you're invested in the market, in these core parts of risk and return, will dictate what your expected return should be in the future. But by all means they are building blocks over and above the risk free rate. The overall interest rate makeup in the system, currently, at this point in time.

Justin Dyer (14:50): Now they can change. And, certainly, some companies will have higher rates of return, looking back, than others. And that's going to happen again. We're going to see another company perform like Tesla did last year. Knowing what that is, or who that is ahead of time is, again, you hear us say time and time again, is all but impossible. And it makes up the market as a whole. And you could look at Tesla and talk about why it returned the way it did it. And even apply a very similar framework. Where the expected future cash flow of Tesla, given what investors have paid for it, is such that it requires this valuation. Now, we can argue whether that is a good model, but someone, somewhere has built that model to validate the price that they're willing to pay. So, anyway, I'll stop there. I know we can continue [crosstalk 00:15:48].

Brandon Averill (15:48): Yeah. I think it's a great point. And I think you hit the nail on the head there. We're talking about long-term investing. What we've seen a plethora of, recently, is trading, and we've talked about this. And when we have the risk-free rate at zero, all of a sudden we have an endless borrowing supply of cheap money. And now you have people that are doing things that, seemingly, don't have building blocks. I think if you go ask traders, you go ask if you're trying to go back to the GameStop, we're trying to buy GameStop, or we're buying the old Dogecoin, or X, Y, and Z. There is no... I would love to hear people talk about like, "Hey, what's your expected return for that investment? And how did you find the building blocks for that?"

Brandon Averill (16:33): So, I think there is a dichotomy happening right now. And it's why we often talk in averages because things do return back to normal. At some point, we're going to see the risk-free rate increase. And it might not be the Fed has come out, and they've been pretty clear that they're not raising Fed rates this year in 2021. So, this whole bonanza may continue to go. We know there's no crystal ball. But as the risk-free rate, it might be a year, it might be three years, it might be five years, as that starts to come up. It is going to return us back to normal in some way or some fashion.

Brandon Averill (17:13): And so, I think having a disciplined strategy as a longterm investor makes this whole process so much more important. And I think there's a great post by Josh Brown, The Reformed Broker. And I encourage people to go read it. But this process, make no mistake about it, it's about providing consistent returns that you deserve for the long-term. We're never going to be at the top. We're never going to be excited about the GameStop type stuff. But when things correct, we're also going to survive that period. We're not going to be shell-shocked by that.

Justin Dyer (17:54): There's a great quote. And I don't know who said it, originally, but, "Markets over the short term can be voting machines. But time and time again, they have proven to be weighing machines over the long-term." What we're talking about right here is a weighing machine. You have to bring it back to the actual, physical properties, if you will, as a corollary to, actually, weighing something. When you're talking about making investments, when you're talking about real money.

Justin Dyer (18:24): And I would just add too, there's some interesting additional risk considerations with these building blocks. You can can think about it with respect to engineered risk. And that's, probably, a big term in a sense, but think about it with leverage. You can invest on margin. You are engineering additional exposure by introducing debt or leverage into the equation.

Justin Dyer (18:53): There's something called optionality, which gives people certain outs, if you will, like a convertible bond. And we might've mentioned that with Silver Lake and this whole GameStop, AMC saga. They had a convertible bond and they were able to take their bond, their debt investment, and turn it into equity. And there's different characteristics and risk involved with that, and expected returns as a result.

Justin Dyer (19:16): And then, you can add some form of manager skill, or luck. We say skill versus luck is hard to differentiate. But in the private markets, we do think that there is an argument for skill. And access, really, is what it comes down to in the private market space where adding some form of risk through exposure to a specific manager that has access, should give us a higher expected return. That's another idiosyncratic building block activism in the hedge fund space and whatnot. But as you start to go down this ladder, your confidence in the probability of success, starts to diminish. It doesn't mean you can't be successful timing the market, necessarily. It's just the probability of you being successful is incredibly low. And it just doesn't make sense to try and take on that additional risk.

Brandon Averill (20:13): I think it's a great point, Justin. And for everybody listening, we appreciate your attention. We definitely took a different spin with this episode. We love to hear from you guys, is this something you enjoy hearing from us? Or do you like our little rants on the current markets? Or do you like this discussion of building blocks, and, actually, how the inside baseball of investing works? So, we'd love to hear from you. Head over to awminsights.com. That's where you can find all the show notes. That's where you can drop us a note. Find us on Instagram, comment. Let us know if you want to cover stuff like this in the future. Because, obviously, we're running up against the clock here. We get passionate about it. And we love to talk about it. So, we'd love to hear from you. And with that, stay humble, stay hungry and always be a pro.