Do You Know What Returns You Should Expect? | Brandon Averill & Justin Dyer | AWM Insights #61

Enjoy AWM Insights? Leave us a 5-star rating & review to help others like you discover the show!

 
 
 
 
 
 
 

Episode Summary

At times investing can seem like a black box. And today, it may feel like you are the only missing out on astronomical returns.

Yet, nothing lasts forever.

It is important to remind yourself for every Crypto speculator who hit the lottery, there are thousands of other tickets that never hit.

The good news is that you can don’t need to bet on the lottery for financial success. You simply need to understand, implement, and stay disciplined to what delivers returns time and time again.

Listen in as we break down the building blocks of returns and how to build a portfolio based on evidence not luck.

 
 

Episode Highlights

  • (03:08): The building blocks of investment returns

  • (09:01): What leads to out performance

  • (13:32): The business model of venture capital

+ Read the Transcript

Brandon Averill (00:00):

Hey everyone, welcome to AWM Insights. It's your power three or today it's actually your power two. We got one CPW and a CFA. We're missing Eric, but we've got Brandon and Justin. At AWM we are a community of athletes, founders, and investors on a journey to be the best at what we do. And we believe you deserve that same when it comes to your wealth. As you know, each week, we cut through the noise of what Wall Street's selling you, and try to bring you the knowledge, skills, and access that you need to invest like a pro. Today we're going to jump into what are those drivers or returns when you're looking at an investment, how do you figure out what you actually do deserve and how to look at the investment landscape as a whole, but as always before we do, let's recap what's going on in the markets around the world. Not quite a market event, but pretty big monumental milestone.

Brandon Averill (00:56):

We had the most populous city in the U.S. Los Angeles. Good old home around the corner here, two days in a row now of zero COVID deaths. So, pretty promising that we might be on the backside of this thing. I know there's still a lot of pain out there, but definitely exciting to see some changes going on there. On the not so good news, the darling of COVID, Peloton got absolutely crushed over the past week. As we unfortunately saw a recall of their tread product, a pretty poor response initially from Peloton and dressing the issue and investors are certainly making them pay now. Beyond that, we had unemployment for April that came in, unfortunately not coming in so well, we had an unemployment tick up to 6.1%. That didn't stop companies from posting really good earnings though, I mean they're just absolutely crushing it overall.

Brandon Averill (01:58):

But what we're also seeing is that a lot of those earnings, those positive earnings might've been priced into the markets and likely were because the market just continues to trade sideways through this period. And we actually saw that tech sold off a little bit and on to sad news, David Swenson, I think most of us in the investment industry certainly look at Mr. Swenson as an inspiration. Led the Yale endowment, pretty phenomenal results is responsible really for most endowment investing nowadays the model for which most endowments allocate their money battled cancer for several years and the investment world lost him yesterday or last or two days ago. So we're sad to see him go, but his ideas are certainly going to influence many, many of investors going forward. But with that, let's jump in Justin. I'd love to have you kick us off here. Let's talk a little bit about what, how do we even form our expectations for returns and for trying to be longterm investors, we're trying to be investors, right? Not speculators. How do we go about that?

Justin Dyer (03:08):

Yeah. And that's a great point to highlight investing versus speculating and David Swenson, rest in peace, if you will, what was a pioneer in really formulating a unique way and thinking about it now, it's his approach was specific to endowments, which are perpetual vehicles, but certainly we take some of what he's done and apply it to individuals and especially when we're dealing with multi-generational wealth, you can apply some of the same ideas and concepts, but it's true. It's investing, it's not speculating. If there is any speculation in a portfolio whatsoever, it better be an incredibly small portion of it. So, where do we start? Well, we're talking about sources of return for broad asset classes, most likely today, or for the most part today and why we focus there is highlighted by Peloton.

Justin Dyer (04:08):

It's a great example of why we don't want to be overly concentrated in any one company, because of the source of return for that company can be what we call is idiosyncratic or incredibly unpredictable, or these events that are quote on quote black swan events. If you will, it might be a little bit of a stretch in definition, but Peloton again, going to that example, there was a nothing wrong with the company itself, per se. You could argue that maybe their product was poorly designed or something like that. But, a treadmill is a treadmill and there was unfortunately a very sad event that happened and it forced them to react. We couldn't, we're never going to play that game and no one's ever going to predict that that's going to happen to any company it's going to come out of left field.

Justin Dyer (05:04):

And so we're going to diversify away from that. And we're going to talk about broad asset classes and sources of return. And we did go into this topic, maybe a month or so ago. And so I'll definitely reference people back to that podcast, because I don't want to go into great detail today, but there building blocks, right? When you're looking at broad asset classes and diversified investing, which again is kind of the one free lunch that you have with investing, you can stack expected rates of return or sources of return on top of each other. So what I mean by that is the foundational building block is what we call the real rate of return, which is or the risk-free rate of return is another way to think about it. And that's buying a U.S. treasury bill that is short term, it's going to mature in the next three to nine months or 12 months.

Justin Dyer (06:01):

And what return are we getting on that? Over and above inflation, that's your base rate of return, then add inflation, your inflation expectation on top of that, because we want to make sure our money keeps up with inflation. And so that those are kind of the, those are the foundational building blocks for fixed income investment, or bond investments. And then going over to the equity side of things, you start to add your equity, risk premium. So, taking what I just said about bonds, let's add an equity risk premium, because we're moving from the debt side of the balance sheet over to the equity side of the balance sheet. I know that's potentially getting a little technical, but they're important differences, what is backing up your investment being the most important one? And so you need to expect more when you're on the equity side, because your risk is higher.

Justin Dyer (07:02):

And then there's some additional factors that you can apply to it, right? If you're looking at small companies in the marketplace, you should expect an additional rate of return or premium playing in that space. The value space is also a proven a different part of the market where a premium should be expected there. And the list of these different categories can be pretty extensive and there's a lot of academic research that backs all of this stuff up, but those are the building blocks of return. And when you start to get away from that, again, we're talking broad asset classes there. When you start to get away from that, you start to introduce concentration risk, going back to the example with Peloton where you can't adequately predict these things, or you can't adequately set your expectations correctly at the beginning of an investment.

Justin Dyer (07:59):

And that can really introduce, well, that introduces lower probability in you succeeding your priorities, your goals, why you're investing really right. And we always go back to that. Why are you investing in the first place? And then really think through the building or construction of your portfolio and making sure you understand the expected return and the expected risk in a very concrete fashion. So, you know that your goals, your priorities, the why is incredibly robust, right? It is, you have a high probability or high likelihood of meeting those probabilities. Again, going back to Peloton as an example, just because it's recent. If you, if all your money was in Peloton, I mean, man, that would be rough. And I guarantee you, someone has a substantial amount of their money in Peloton, because it was a hot stock and people chase returns.

Brandon Averill (09:01):

Yeah. I think that's a great point. And I want to be clear what we're not saying here is that we're not looking for out performance. We are absolutely looking for out performance. I think that often times gets missed, when you talk about diversification, you talk about not being able to predict the future, whether at the market level or at the company level, there are still ways to expect higher returns than the average. And that's what we certainly subscribe to and I think you hit on it Justin. There's a wealth of academic research out there into what actually drives returns, right? And you just went through some of the building blocks, but expect a returns do depend on what the current market prices and then the expectation of future cash flows, which not to diverge is why we have such a tough time with things like Bitcoin or Ethereum, or NFTs or gold, quite frankly, like if it's not generating a cashflow, how do you ascertain a value and how do you actually start to do this calculation of what to expect?

Brandon Averill (10:02):

Because I think where people also lose sight is you should have an expective return, because risk and return are related. So when you're, if you can't figure out what your expective return is, then you can't relate the risk. And if you can't relate the risk, then you just might put yourself in a situation where you're taking on an incredible amount of risk. And you're not going to get rewarded for it or if you do get rewarded for it, you have no context whether you actually got enough of a reward. So just, because something goes up in value, we talk about this with private real estate a lot, people think they're getting this great value, and then you break it down. It's like, well, you actually got about a three percent return.

Brandon Averill (10:46):

You should have just taken your money and put it in the SFP-500 or into a REIT or whatever. I think it's, you have to have expectations on both sides, the return, and then relate the risk to it. So I think, investors can use this information. We use this information, this academic research to write, go to the end of that building block, like you just described Justin and it's okay, we're going to accept that market premium. We know we need a return for that. We know that over time, the evidence shows that the size of the company matters. So we're going to invest more in small cap. Now we're still not going all eggs in that basket, right? Because it doesn't always work. Nothing shows up all the time, but we're going to over wait.

Brandon Averill (11:36):

We're going to put a little bit more there. The same thing goes with the illiquidity premium. I think this is something people miss it's like, you should get paid for tying up your money. If you're going to go invest in private real estate or a private company, we talk about venture capital a lot. If you're going to tie up your money in a venture capital investment for 10 years, which most reputable, at least venture capital investments are going to be for a 10 year period. You should expect higher returns, it's higher level risk. So your risk premium should be higher. It's liquidity risk. So you, again, so you start these building blocks, right? And I think if people can start to think about it that way, okay, what are my building blocks for my expected returns here?

Brandon Averill (12:23):

And I want to also be clear, we don't live in averages so we can have an expected return for this year, last year. Great example, we had an expected return for the equity markets was probably somewhere between six and a half and seven and a half percent for the large U.S. companies and returned what like 50. I mean, so you're going to have years, right? This isn't meant to be like we're dialing in every single year. This is a long term average. We're going to have volatility. It's rarely going to be right what your expective return is, but without an expective return, you can't put together a proper plan. It's relating to a lot of the athletes listening. We had this conversation with actually an agent yesterday he's like, "Oh I sleep great". How do you know, do you wear a whoop? Do you measure it? Do you have any idea? Because you're overweight, you're tired, but you say you sleep well, this isn't adding up, right? You have no way to measure it. So figure out a way to measure it.

Justin Dyer (13:24):

Your brain is not your friend, right?

Brandon Averill (13:27):

Yeah, totally.

Justin Dyer (13:32):

I want to latch onto the venture side of this a little bit too, because I think that's a great microcosm to focus on. I mean, everything you said, illiquidity is important there, in some cases, these are startup companies with no revenue stream, it's just a business model, but I think it's often lost. And if you dig deep enough you can see these statistics, but you, we in the financial media and the media in general only see the extreme winners tied to venture capital. And those are important, because those are what drive returns. But when a venture capitalist is making their investment, distributing the money across their portfolio of investments, whatever their focus is maybe its series A, B, angel, whatever it is, right. They have expected returns built into those decisions.

Justin Dyer (14:29):

And they, part of that as well is an expected amount of companies that are going to fail. And if you saw what that was, it's substantial. And so it's important to always kind of frame what you're seeing in the media, especially when it comes to venture in these high flyers, Coinbase, being a big one that, they just went public and have come back quite a bit, come back to earth so to speak quite a bit and the IPO, ETF, ticker is IPO down 14% per year. That is kind of a high that is highlighting this transition from venture into the public markets. And it's highlighting the risk and return side of it, right? These are risky companies that are going public still at that point in time, hopefully they have a business model and revenue and cash flows and everything you just said.

Justin Dyer (15:25):

And there's some sort of valuation formula there, but there still is a lot of risk. And you're kind of seeing that right now in the marketplace. But I get with venture, I think it's a great example. We, I was listening to an annual meeting with a fund that we do business with and one of their more recent funds, which is kind of a call it a higher octane, higher risk, high reward type fund has done incredibly well. It's been around for about a year and they've knocked it out of the park with a couple investments. And they themselves qualify the returns that they're presenting and say, we know this is not sustainable, because our, their expected returns are less. They know that this, it could continue, but it's not likely to, because of the expectations, the amount of companies that they know might not make it, or it might just break even knocking it.

Justin Dyer (16:19):

They're not going to go public at a two, three, four times multiple to what the fund invested in. So, I know that's going a little into, in depth on that, but it is a important microcosm, because it's also something that's sexy and covered quite a bit in the media, around the big IPO names, especially over the last six months with all this facts and whatnot. And it's very important to take a step back and say, well, behind every SPAC or every IPO, there was probably eight companies that failed or barely made it.

Brandon Averill (16:51):

Yeah. Yeah, no I think it's a great point. And kind of tying it back a little bit before we're close to expective returns and consider the drivers of returns. I think venture capital is a great place to turn, because right, what determines your return as a venture capitalists are these big outlier wins. I think what you're getting out, right? It's a power law distribution, right? We're used to this bell curve that everybody probably knows this, even distribution, 80% is going to fall within one standard deviation or 68% or whatever it is. We have, we're going to have some winners, we're going to have some losers, et cetera, but it's the average is a good place to look. The average is the last place you're going to look in venture capital, right? And it's a completely different distribution.

Brandon Averill (17:40):

And so, if you're not accessing the areas, those places that the winners keep winning that mentality information incredibly inefficient in the private markets, right? It's one reason you want to be rewarded for investing in the private markets, but public markets, we're seeing this, is that what would have happened if Peloton recalled their treads when they were still private, maybe they have a down round, but if they would've had enough cash, they probably could have recalled all the treads, because their business metrics are actually still pretty good. And whether that storm got the business into a better spot before they raised additional capital. But now it goes into the public markets and what happens, the public markets recognize a change of information and now the prices is reflecting that information. So, it's a different beast to all the way around.

Brandon Averill (18:36):

So when you're considering investments in different places, or you got to have a good understanding of the building blocks of the return that you're actually expecting from those different investments. So, we invest in venture, because it should produce higher expective returns over time with the right managers. If we had not, if we didn't have the access that we had to have to the venture capital market, we wouldn't touch the stuff with a 10 foot pole. You would never go buy the index and venture capital that is insane. Like nobody would ever do that. It's underperformed the Nasdaq I think, you just would never do it, but so I think you've got to be careful around that. But anyways, we've talked far too long. So, if you'd like to hear any more about what we've hit on today, we encourage you to head over to AWM Insights.com, download those 10 key principles to investing like a pro. You heard about one of them today. So we appreciate your attention. And until next time own your wealth, make an impact and always be a pro.

 
AWM InsightsAWM CapitalJustin Dyer, Erik Averill