Does More Risk Always Mean More Return? | Erik Averill & Justin Dyer | AWM Insights #77

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Episode Summary

Following our deep dive into risk on last week’s episode, we received a listener question asking if risk and return are always perfectly related.

Absolutely not.

Simply taking on more risk doesn’t lead to more success. There are different types of risks that are important to understand before introducing added risk into your portfolio.

Erik and Justin continue the conversation this week to explain the differences in risk and the importance of making sure you’re compensated for the type of risk that you take on.

 


Episode Highlights

  • (1:30) The news you should know: Federal Reserve meeting, Rivian is going public, and social media stars who move markets.

  • (6:24) While risk and return are related, not all risks are well compensated

  • (7:50) You can never know 100% of the risk

  • (8:56) The two important questions to ask

  • (10:44) Taking calculated risk

  • (12:45) Participating in owning companies over the long-term to capture the market premium

  • (14:23) Why smaller companies generally outperform versus large companies

  • (16:49) The evidence of well compensated risk

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Justin Dyer: LinkedIn
Erik Averill: LinkedIn | Instagram

+ Read the Transcript

Erik Averill (00:00):

Hey, everyone. Welcome back to AWM Insights. It's Erik and Justin today. And each week we are here to cut through the noise of what Wall Street is selling you, to bring you the knowledge, skills, and access you need to invest like a pro. And picking up from our conversation last week, where we went into depth of defining the conversation around what is risk, and how to properly think about that as an investor. One of the follow-up questions we received was, "Is risk and return always perfectly related?" Meaning if I take more risk, does that mean I'm always going to get higher returns? And of course the answer is, "Absolutely not."

Justin Dyer (00:50):

No.

Erik Averill (00:50):

There is a difference in risk. And so today we want to make sure that we clarify that, that what we talk about is you should be compensated for the type of risks that you take, simply taking more risk does not lead to more success. And so that seems like of course that makes sense, but we are going to dive into that, so you can have the highest amount of confidence possible when you are stepping in to introducing risk to your portfolio. But before we do that, Justin, bring us up to speed on what's been going on in the news.

Justin Dyer (01:30):

Sure. So big week on the Federal Reserve front, that lovely topic, super interesting, but obviously very, very, very important. There's a big conference once a year that they have in Jackson Hole that happened this week. And really what has been supporting or led to a strong close, at least as of this recording, for the markets was Jerome Powell, the chair of the Federal Reserve really basically coming out clarifying that the stimulus that's been in place since March of last year, essentially, to support the COVID correction and the economic effects is going to start to taper. He was really clear that it looks like it's going to happen sometime later this year, markets like that.

Justin Dyer (02:20):

Some people are saying that it's later than they expected. This is a whole nother topic, right? How we try, and each and every day you log in to CNBC, or turn it on, or go to Bloomberg, wherever it may be,, and there's some headline, "Markets are up because Powell said XYZ." And there's always some explanation, and at the end of the day, it's really hard to tell, but markets definitely don't like uncertainty, and maybe he's providing a little bit more clarity on that front. So that could be what's really supporting markets.

Justin Dyer (02:50):

And, hey, he's saying the economy looks strong, so those are pretty good items for equity investors overall. Additionally, I would say something to note is Rivian, who's probably Tesla's biggest competitor, in terms of the actual product they have developed, orders, backing. They're filing to go public, and guess what? They're doing it the old fashioned way, not via SPAC, or direct listing, or anything like that.

Erik Averill (03:19):

Wow, no reverse?

Justin Dyer (03:19):

Yeah.

Erik Averill (03:20):

Wow. This is fascinating.

Justin Dyer (03:22):

Believe it or not. And then another just interesting item I came across, this is a whole different podcast, but maybe relates to what we're talking about today. There's an article in the Wall Street Journal titled, "The Social Media Stars Who Move Markets." Fascinating, right? With this whole meme stock environment that we're in. And the subheading was, "The only rule for these would be Jim Cramer's." If you guys know who that is, he's a big CNBC personality, talks about stocks all the time. "The only rule is you cannot disagree with the meme stocks." And I just find that absolutely fascinating, because it's basically acknowledging, "Hey, these guys can't actually provide advice. They're just telling you what you want to hear, and getting your eyeballs, getting your clicks, not serving in your best interest." So again, another topic altogether.

Erik Averill (04:11):

Well, and it brings us back to where are we getting our information? At the end of the day, when we make investments as individuals, what we're trying to do on its most basic level is how do I have the highest confidence that when I take my money, and I invest it, that I am going to increase the value over the longterm? Right? How is my money going to make money? And what that news article actually says is, "If your news source of what's giving you confidence is what you're reading online via on social or on a entertainment news platform that makes their money off of advertising and revenue, you should have low confidence, and there's not a lot of evidence there."

Erik Averill (05:05):

So I think we all know that intuitively that we live in these echo chambers. So today we want to give you an alternative route to say, "What does the evidence say? What do the professionals do when it comes to making their investment decisions?" And before we dive into the specifics of the sources of returns, that's where we want to take you on this journey in this next conversation. So for some reason, if you've got to tune out and jump back into this conversation later, what we're saying is there is evidence that will give you confidence of how to make sure that you're capturing the returns you deserve based off of the risk.

Erik Averill (05:47):

And big spoiler alert, the biggest driver of the return is something called enterprise risk, which means the actual underlying business that you're investing in is you want to look at the type of businesses, not necessarily the trends and movement of the overall market, but really what is the value of the business? And the type of business is going to drive the returns that you have. And so, Justin, walk us into this conversation of while risk and return are related, not all risks are well compensated.

Justin Dyer (06:24):

Yeah. I mean, that's an absolutely critical point. Just by going in and taking single stock risk does not guarantee you a better outcome. So the simple way to kind of to frame this before we get into some definitions is by taking more risk, you're not guaranteed to have a higher probability of a better outcome. Right? That's what it is. You go to Vegas, we all know Vegas, the odds are stacked against us, but people still love going there and taking risk. They risk their money, and they have what did we say? It's something like a 35%, 37% probability of winning. I mean, that's terrible. That's insane.

Justin Dyer (07:07):

Whereas what we want to do is look at the evidence, like Eric was saying, look at the evidence, and figure out where we can take risks to increase that probability of success, that compensation for taking that risk. And like you said, the main starting point for that is what we would call enterprise risk, and you could even expand that to systemic risk. Right? We want to put our money into the market, and it is exposed to the economic growth of a country. Right? And those are drivers that then go into the company specific aspects that you are highlighting, Eric.

Justin Dyer (07:50):

And that's overall what drives, lifts all these boats,, or sinks all these boats on average. And I think it's also critical to highlight that you wouldn't want to put all your eggs in one basket. Right? We know that. You're not going to just because we say, "Oh, wait. This is a good company, we understand their specific risk. We're going to put our eggs in that one basket." Because guess what? You can never know 100% of the risk. You can never quantify it, and you can never isolate it completely.

Erik Averill (08:18):

And I think that's an important point to make right there is if somebody is selling you certainty and guarantees of a can't miss, this always goes up, those type of comments should make you pause, because we want to operate in this belief that we can guarantee outcomes. That is just not the case. We don't live in a world that is predictable like a casino odds. Right? So what we want to do is say, "What is the best probability, and what gives the highest confidence?"

Erik Averill (08:56):

And so us having this conversation with a client the other day, who is very interested in the trading card market. He's a professional athlete. He sees that these things are happening, and very, very intelligent client of ours. And we were having this conversation of he truly understands it is speculation of what he's doing, and he's willing to risk this capital, because the two questions I had for him was, "First and foremost, what amount of confidence do you have that you are going to make a positive return when you buy some trading cards?" And that confidence is really based off of question two, "How can you reliably figure out what the value of this trading card is going to be in the future? How do you derive a value from that?"

Erik Averill (09:54):

And once he understood, hey, I can't really derive a value based off of there's no future cash flows, these types of things, he goes, "Now I understand why I don't have a lot of confidence in that." And so to relate it back to so much what you do in your daily life as a listener, think about your own job. If somebody has to do what you do every day, whether it's you're a professional athlete, or you lead a team at a company, is if you said, "I'm going to have confidence in this person to do the job." There are certain benchmarks, or there are certain ways that lead to success. And that's really what Justin is about to break down is saying, "You can have confidence of where you invest your money, because there is evidence that lays out this is what leads to returns, therefore gives you high confidence."

Justin Dyer (10:44):

Yeah. And you know what we're talking about here is calculated risk. That's what matters. To your point in your conversation, you don't want to just blindly take risks, throw whatever darts at a dartboard blindly or at a newspaper, and make your decision. Right? That is a very low probability way about going and doing things. So what do we do? We look at the evidence. So we take thoughtful, calculated risks. So we are comfortable and confident, to use that word again, that we should be compensated for taking that risk. The baseline point that we start is we want to understand what are the core drivers of risk within the market?

Justin Dyer (11:41):

And not to go too far into the academic world, but there was a very famous paper in the early nineties, from Eugene Fama and Kenneth French, they ended up winning a Nobel Prize for it. It's, from what I understand, one of the most tested academic theories or papers out there, and it's actually stood the test of time. And basically, what they did is they said, "Okay, we want to see where we understand what happens within the market. It's a big collection of different companies that trade, but where is return coming from? And second to that is where is risk coming from?" And basically what they identified, and we'll go into this more in a couple other podcasts, is that, okay, well, first and foremost, just participating in the market provides some amount of return, and it's actually a great return, by the way. I just saw statistics since over the last 140 years, the S&P 500, I believe it was, returned 9.2% on average. I mean, I'll take that each and every day.

Erik Averill (12:44):

And before you move on, Justin, I just want to clarify for our listeners, when we say, "The market," the reason there's this premium that you're being rewarded is because what's happening, once again the market is just a location that you show up to, and you're investing money in businesses. And what happens is we're giving our money to a company like a Microsoft, a Google, or Rivian who's just filing public, and we're saying, "Take our money, build products and services that take time." Right? They have to do research, they have to do development. They have to do marketing, "but over time, as you create products and services, and consumers pay money for that, I am going to get my money back and more, because the value of that company is increased."

Erik Averill (13:37):

And so that market premium says if I put my money into the market in aggregate where I have exposure to 10,000 plus companies, some of those individual companies are going to fail, but by and large part in a capitalistic consumer world, we know that people are going to continue to buy goods and services over the long-term, and that's why we have high confidence that there is going to be a return on our investment, and that is why we are rewarded with the premium. And so it's why we push so hard against don't worry about what the Fed said, and try and predict where in the short term the markets are going to go. We're participating in owning companies over the long-term to capture that market premium.

Justin Dyer (14:23):

Yeah. Long-term is critical in this entire conversation. I mean, it helps you really get that confidence, get to that place of confidence. A couple other parts of the market where you can identify distinct drivers of return, and we mentioned these, we alluded to these time and time again, but it's the smaller companies. So smaller companies versus large companies generally outperform, not each and every year, but they generally outperform. Why? Well, it's actually tied directly to this conversation. They're a little bit more risky. They're smaller. They have the chance to potentially go out of business easier than a Microsoft does. Their cost of capital, and we'll get into exactly what that is in a sec, their cost of capital is higher, which ties back into our expected return. So smaller companies you should expect to earn more over time.

Justin Dyer (15:16):

Again, not each and every year, but you should expect that, and that's what history, what the evidence has showed us, again, over very, very long periods of time. Another part of the market is value oriented companies. So these are companies that are trading at a lower multiple to any pick your multiple, but a lower multiple to revenue, to earnings than say a growth company which is trading at a much higher multiple. And really the logic there is that people think that they're just going to continue to grow, continue to grow, grow, grow, grow. And what generally happens is that those heightened expectations for growth companies are just so hard to actually meet. And so you're paying so much for future growth, and that's kind of the rationale there.

Justin Dyer (16:01):

And then on the bond side really important is you can take... So the risk-free rate or the risk-free asset, let's start there, is a treasury. And then outside of that, you can take on credit risk. And that's an additional driver of return on the bond side of the market. You can take on term risk as well. And that's just simply saying, "Oh, I'm going to lend my money out, or buy a bond for five years, or I'm going to buy a bond for 10 years." If you do it for 10 years, you should expect a higher return. And those are the tried and true core building blocks of return in the market. This is that systemic risk, that enterprise risk that really has been studied, tested, and has been proven to be the core building blocks and sources of return and well compensated return in the market.

Erik Averill (16:49):

Yeah. And I think that last point, well compensated, right? So it's one of these things when we look at the data. So when we talk about small versus large companies, if you're in the top decile, the top 10%, your annualized return from 1927 to 2019 is 11.27%, very, very good. If you allocate to the bottom 10%, so theoretically, the more risky of that group, the returns are 18.25%. And so there we see in the evidence that you are being compensated for the additional risk you're entering into your portfolio. And I think, Justin, what you pointed out is so important of why you have to think long-term, and also why what we're not saying, to be very clear, is we're not telling you to go try and sharp shoot, and pick the individual stock that happens to be the smallest value stock out of 10,000. Right? That is foolishness. That is an amateur move.

Erik Averill (17:56):

If you are picking individual stocks, or if you open up your portfolio, and you have individual stocks, you need to fire that financial advisor, i.e., the broker who doesn't understand compensated risk, because what we're saying is we're allocating to a factor in the overall market. Right? That there is a universe of companies that are defined by that, because there is no reliable evidence. There is no high confidence that you can predict which specific company is going to meet this, and so I just think that that's really important to mention. The other thing that was super helpful, when you mentioned this word cost of capital, financial jargon that's like, "Oh my goodness," my eyes roll back in my head.

Erik Averill (18:39):

Let's make this really tangible. Right? Is when we're talking about risk-return, cost of capital means if I'm a business, so if I'm Microsoft, the only AAA rated company that's publicly traded, which means they have a very strong reputation that they're going to pay you back. So if I lend my money to Microsoft, so they can use it to do whatever they want to do some research and development, there is a very high confidence that they're going to pay me back, and they're going to give me a little interest. Because they are so trustworthy, a lot of people are willing to loan them money. And the interest rate I get back is going to be really low, maybe call it 2%. And that's because there's not a lot of risk there. However, let's use Peloton.

Justin Dyer (19:30):

Rivian or Peloton.

Erik Averill (19:30):

Or Rivian. Yeah.

Justin Dyer (19:35):

Yeah. I was just going to go there. Yeah. I mean, you could say, "Well, look, these guys don't even have customer. They don't have revenue yet." Just think about that. Now, it doesn't mean you shouldn't lend money to them, but if you lend money to them, you better charge them more than you're charging Microsoft. Right? And that is their cost of capital, but it's more risky for you, so you expect a higher return. I mean, it's kind of that simple.

Erik Averill (20:01):

Yeah. And to your point of the compensated risks is so important here, because we see this mistake made again and again in the amateur world of when we see brokers take advantage of retirees that say, "Hey, we don't actually care about the underlying company that's providing the high yield, the returns." Right? Or we see this in closed in fund world is it's like, "Well, the yield is there. The yield is there." Well, there is underlying risk of these businesses, and so you want to just make sure that you're being compensated for that. And so just another thing that you had mentioned, Justin, is there's going to be a lot of critique that, "Well, value is dead, or these factors are dead." What we're not saying is they're not going to show up every year, but if you're a long-term investor, this goes back to having the proper financial structure, and allocating to the right investments based off of your priorities and timeframes is if you are a long-term investor, we're talking probabilities of north of 80% that these factors show up.

Erik Averill (21:07):

And so we'll make sure to link some stuff in the show notes, as Justin said, we're going to dive deep into all of these topics in future episodes, because really what we want to bring you is this is the best way based off of the evidence to have the highest confidence in the returns that you deserve. And so we appreciate your guys's attention to this. As you can tell, we get super excited. We know you've worked extremely hard for your money. We want to make sure that you're compensated for the risk that you take, ultimately, so that you can have the most amount of money to achieve the priorities, and to live the life that you envision, and that you deserve. And so until next time, own your wealth, make an impact, and always be a pro.