The prevailing theory in finance is that the more risk you take, the more return you get. In other words, they are directly correlated. Otherwise, why would you take the additional risk? A simple but important part of the risk vs. return theory is that the more risk you take, the higher the prospective return you get. If higher risk guaranteed higher return, there wouldn’t be any risk at all.
It’s easy to understand how the risk vs. return model was developed. A “risk-free” U.S. Government bond typically pays the lowest interest rate – the 2-year U.S. treasury note yields around 2.3% right now. U.S. Government bonds are considered risk free because there is almost no chance that the government will default on its bonds, making it a pretty safe investment.
Alternatively, purchasing two-year corporate bonds is more risky because a corporation is more likely to default, so the yield on the bonds will be higher than a U.S. Government bond. The riskier the issuing company, the higher the yield. The risk vs. return relationship generally holds true for bonds, especially those considered investment grade.
A stock, on the other hand, has a less clear relationship between risk and return. In fact, it can sometimes work in opposite fashion, meaning that you can get higher return while taking on less risk. Why is that true?
Risk is a function of the price that you pay and the value you get in return for that price. If you pay more than the value you get for an investment, it is highly risky. If you pay less than the value you get for an investment, it carries lower risk. This means that in order to evaluate how much risk you are taking, you need to be able to value an asset, regardless of what the asset is – a house, a stock, a bond, an apartment building, etc.
When I make an investment, I focus first on determining a range of value for a business. There are a lot of variables that go into estimating the value of a business – cash flows, growth rates, discount values – all of which are trying to predict the future. It’s easier to determine a reasonable range for those variables than it is to try and be precise.
Once a reasonable range of value is determined, it needs to be compared to the price of the business. If the business sells below the range of value, there is less risk in making the investment. Incidentally, there are also higher prospective returns with the investment because you have the added return attributable to the price/value gap closing.
If a business sells above the range of estimated value, it carries with it additional risk. Prospective returns are also lower because the price/value gap will eventually close. Therefore, you earn less prospective return with higher risk.
There is a third situation where a business sells at a price within the range of its underlying value. This situation is probably most prevalent in the market and most consistent with an efficient market. When a business sells at a price equal to its underlying value, the risk vs. return relationship where higher risk provides higher prospective returns holds true. If you believe that price always equals underlying value – spoiler alert, I don’t – then the risk vs. return relationship holds true.
I try to find businesses where I can buy them for significantly less than their underlying value, providing higher prospective returns with less risk. Overpaying for investments, especially as markets climb, is caused by a lack of patience and discipline from investors.
U.S. markets have been expensive on an aggregate basis for a while now. The end of 2018 started to close the gap between price and value across the market, but the correction was short lived. Markets have since taken off in 2019. We just recently hit new all-time highs in the U.S., in a market that I believe is priced above its underlying value. Remember, the more you pay in relation to value, the more risk you take on.
Lower prices are better for investors – we just never act like they are.