Part 2 of the series: Rethink the Way You Invest.
“There’s no such thing as a free lunch.”
This phrase was misattributed to the economist Milton Friedman but its origin actually dates back to a 19th century practice in American bars of offering a free lunch to entice the more lucrative drinking customers. There was usually no real net bargain to the patrons, as the higher margins on the ale quickly soaked up any savings on the lunch!
The same goes with our investments. Risk and return are very closely related as I alluded to in my last article. For every incremental increase in risk, we need to undertake an additional level of risk. Put simply, you can’t get a higher return for free. The price is in the additional risk.
Only certain risks offer an expected reward – and science has helped identify these risks. For our purposes, we will confine our discussion of risk and reward to the most studied category, stocks, also known as equities.
The two major equity risks are size and price (or value).
In regards to “size risk”, there is a whole spectrum of companies listed on stock exchanges, from the very small and risky ones to those large and “safer” stocks. As a prime example of this, when was the last time that you saw a government bail out a small, little known company versus a huge corporation employing thousands of citizens? Although the market needs to price its riskier smaller stocks down in order to attract our investment capital, on average we are rewarded with a higher return.
“Price risk” refers to whether the market has sold down the price of a stock due to real and perceived risk (value stocks) or whether it has bid the value up to reflect the fact that it’s held in high regard because of real or potential earnings growth (growth stocks). Imagine the stock market as a department store. Are potential buyers eagerly lined up outside, or do we need a 50% sale to attract our interest? Although I usually buy when goods are on sale, my risk is that I will get merchandise that is out of favour for various reasons. If there’s quality there, I may be willing to pay full price though. Getting the picture?
The fact is that there is a broad diversification of small, medium and large companies that are priced at a discount, regular price, or going for a premium and I want to own them all around the world in order to increase my expected returns and reduce portfolio volatility.
The next challenge lies in how best to invest in these stocks rather than speculate in them. I’ll save that discussion for next time.
Click here for Part 3: “Failure of the Really Smart People.”