Misconceptions of risk cause poor investment decisions
Confusing volatility with risk will lead to bad outcomes
While a Vice President of GE Canada, I worked with a colleague who understood risk in the heavy apparatus business more correctly than most. He had a saying “Every time you make a bid, you run the risk of getting the order”. He understood that bids are based on models of outcomes and actually doing the work doesn’t always conform to the model’s assumptions or expectations. The recent run up in the capital cost of the TMX pipeline (which has tripled in estimated cost since it began) is a good example. Risk is not volatility in share prices, it is outcomes that punish investors when operations of underlying companies fail to meet projections built in to investors’ expectations in the price discovery process called the market.
Financial theorists write volumes about discounted cash flows, present values and future values and typically ignore the reality that reinvestment risk is inherent in their analysis. If an investor is unable to reinvest cash flows received during the life of an investment at a rate greater or equal to the rate used in the Net Present Value calculation, the result will be a disappointment. Too much of current financial theory focuses on price rather than operating success or failure. Hordes of analysts get paid six figure salaries and bonuses to come on Bloomberg or MSNBC to parse the first derivative of the random changes in trading price as if it had some predictive value, and universally they are disappointed when prices fall and ecstatic when they rise - share prices that is.
Reality is that investors benefit from lower share prices, not higher ones, if the change in price does not reflect a change in the profitability of the underlying business. Businesses have a lot of momentum and their operating outcomes don’t often change in a matter of a day or two, but the talking heads can’t stop themselves from claiming a small change in the trading price over a day or two is a harbinger of great things ahead or a collapse of the company. It is theatre of the absurd.
In today’s market, the concept of U.S. 10-year treasuries comprising “risk free” investments is beyond absurd. The carnage in the fixed income market at all durations over the past couple of years demonstrates that using the yield on the 10-year treasury as the “risk free rate” (typical of many financial “experts”) is not only wrong but also foolish. An intrinsic “risk free” rate is the sum of global GDP growth and inflation, since it is a rate below which investors suffer real losses on investments.
It should surprise no one that the typical fund manager or portfolio manager earns returns for clients that are less than the market averages. In the last fifteen years, one analysis of U.S. fund managers found that one (precisely one) of the thousands claimign great insights actually produced a return that beat the market average. All of them were paid by clients for sub-par outcomes except one. And, that one was a “buy and hold” manager.
Technical analysts are the worst of the lot. They think charts of past performance (performance being daily share prices presented as charts) have predictive value and recommend trading based on their interpretation of the charts. It is about as useful as astrology to predict the future, yet it has many adherents.
In an ideal world, one with a market that was in fact efficient, investors in a company would earn a rate of return equal to the return on equity of the company over an extended period. But they don’t. They earn substantially less. The gap between what the company’s they own earn on the equity they own and what they get for owning that equity is largely the costs of the “wealth management” and trading industry that feeds on public investors. And they eat well, with many becoming billionaires and most receiving salaries and bonuses far greater than the average for society as a whole or most professions.
The real long term risk for investors is that the share prices of the companies in which they are invested trade higher than intrinsic value, making reinvestment of dividends or investment of new funds earn lower returns. Think about it - higher prices for shares compels lower returns to investors. Many think - “but I can sell at a profit”. They can, and they will pay trading fees and commissions and be forced to find another investment that is at least as good as the one they sold, while the person who purchased the shares they steps into their shoes and as a class, the total set of investors earns less.
The only investment approach that has merit is to buy interests in companies that the market has undervalued (and you need some expertise in business valuation to find them) and keep them for decades, hoping for a growing stream of dividends. Share repurchases, a favorite of many fund managers and investors, can fuel higher share prices for those who retain their shares but necessarily cause those who sold into the buyback to suffer a poorer result if the buyback in fact does have that effect. Taken together, the total set of investors in the company did not benefit from the buyback and at best stood pat except for the costs of the trades. You cannot create value out of nothing and the buyback fad pits one group of shareholders against another with the combined shareholder group necessarily worse off as a group.
Volatility is not risk, it is opportunity for some investors and risks for others. Wide swings in the market prices of sound companies creates the opportunity to expand ownership at discounted prices, again at the expense of the poor bloke on the other side of the trade and with the incumbent trading costs making both investors taken together worse off. Sensible investors ignore volatility and are immune to the temptation to trade.
Pay attention to actual risk and avoid buying into dated financial theories that have yet to demonstrate robust outcomes.