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Why expected returns differ

2022-03-09, Michael Thompson

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Why expected returns differ

How can one stock have a higher expected return than another? It’s a paradox: if a consensus says stock A has a higher expected return than B, wouldn’t people just sell B and buy A—driving up the price of A—until the expected returns were equal?

The answer is no. In this article, I’ll explain why different investments can have different expected returns. It’s one of the most important fundamentals of investing. We’ll use it to see why most investors prefer diversification and index funds, and why advisors discourage short-term equity investments. We start with a simple analogy.

Which card would you choose?

Let’s say I have two Amazon gift cards: card A and card B. I just verified card A is worth $800. I’m not sure about card B, but I can say with 80% confidence it’s worth $1,000, otherwise (20%) it’s used up and worth $0. Which card would you select?

Most people will pick card A. The expected reward is the same—$800 or 80% of $1,000—in both cases. Experiments have shown that, when the expected reward is the same, most people will choose the more definite option, minimizing risk/randomness. Apparently, the potential pain of receiving $0 in card B trumps the likely thrill of getting an extra $200.

All else equal, people prefer a certain outcome over a risky outcome. If you want to read more about the psychology, check out prospect theory. It follows that people will pay more for a certain outcome. If I’m selling these cards, I will be able to sell card A for more than B. For example, I may be able to sell card A for $780 and B for $770. In this case, the expected return for card A will be $20 ($800-$780) and the expected return for card B will be $30 ($800-$770). So you see a reason for different expected returns.

Stocks Vs. Bonds

Let’s look at a treasury bond compared to a stock now. There are various types of treasury bonds, but assume we have the option to buy one that compounds at 3% annual interest. On the other hand, we could invest in company S that sells shoes. If business continues as usual, they will earn you about 5% annual interest. Is it obvious that we should invest in S to get the superior expected return?

Since the US has never defaulted on its obligations, the treasury bond is analogous to the $800 gift card in the prior example—it provides a highly certain payout. Businesses like S, however, often fail to meet expectations, and they sometimes go completely broke. High unemployment could choke consumer spending, inflation could increase costs and reduce profits, or a pandemic could close stores that sell their shoes. Investing in S is more like buying card B in the prior example. Investors therefore demand a higher expected return from S (in exchange for taking on more risk).

Hopefully you understand now why some people will choose to buy a bond, despite a lower expected return. If so, you’ve understood a major concept in investing.

Stock Vs. Stock

Now let’s consider two stocks S and T. Assume S has existed for 40 years, has a loyal customer base, low debt, and predictable annual profits. Company T, on the other hand, is a recent start-up, aiming to develop a new type of television. This company has debt with little revenue. If their technology works out, they could make billions, but otherwise they will go under.

Which of these stocks should have a higher expected return? Company T. Why? Just like gift card B in the first example, there’s a larger risk that T could earn nothing. The company could go broke with a $0 stock price. Given what we said about S, and the fact that essentially everyone will likely buy shoes in the foreseeable future, it’s more likely that S will earn profits for their shareholders. A downside with S is that it’s less likely they will have a substantial increase in profits.

So you see, even among stocks, there is a fundamental reason for different expected returns. This opens the door to a trick that we should discuss now. There’s a way to get the higher expected return in T, but with less risk!

The diversification trick

Let’s replace stock S in the prior example with an index fund F. We compare buying F to buying shares of T.

This index fund F is spread across the stock of 500 different companies, each in a similar financial situation as T. Some companies in F will succeed, earning huge profits for their investors. Others will fail, losing all their shareholders' money. Poor performance from one company will not impact F too much; it will be offset by high performers. As you might imagine, F is generally a lower risk investment than T.

Given the lower risk of F, we should anticipate lower expected returns, right? Not really! This is the power of diversification. The expected return for F is just an average of the expected returns from the constituent companies. If T and all the constituent companies in F have an expected return of 12%, the expected return of F is 12%!

The only reduction in returns from using F is typically an expense ratio ER. In recent years, these ERs have shrunk. Many good funds now have ERs below 0.05% (index funds keep getting better).

So why do people still buy individual stocks like T? There are an infinite number of ways to estimate the expected return of a company. While my method may predict 12% returns, Joe’s method may predict 15% returns. If Joe is confident, he may go ahead and buy T, instead of F, because he foresees enough excess return to justify the risk.

Joe must realize, however, that the current price of stock S is a consensus formed by all the potential buyers/sellers, with all available information. If a consensus thought the returns would be larger, they would’ve already bought the stock and driven the price up until the excess return vanished.

Exceptions

An index fund is not always a safer bet than an individual stock. Some index funds are focused on specific industries, countries or regions of the world. There are many events that could trigger all the companies in such index funds to underperform simultaneously. For example, the fund F discussed above may be very sensitive to interest rates. Most of the constituent companies may go under if their cost of capital increases much. At the time of this writing, the RSX index fund (a collection of Russian companies), is down almost 80% in the last month! On the flip side, there are individual stocks like Berkshire Hathaway that hold a good diversity of businesses around the world. It would be hard to argue that RSX is safer than BRK.

Correlation

As the exception above highlighted, it’s really about the correlation of the expected returns from the securities in a fund. Diversifying across 10 or 1,000 businesses is less helpful if they’re highly correlated, i.e. if they are all subject to the same risks and go up/down in the same way. In fact, if all the businesses in a fund were perfectly correlated, then there would be no benefit to buying the fund rather than shares in just one business within the fund. The real power comes from owning uncorrelated assets: when one goes down, the other goes up. Diversification only lowers risk if the assets are uncorrelated. For example, this is one of the reasons for holding stocks and bonds.

Time

There’s one more point I’d like to make here. Stock markets are more reliable over longer time periods. The returns of the S&P 500, for example, have ranged from below -40% to over 50% in specific years. The long-term average annual return is close to 12%. The longer you’re in the market, the more stable/predictable your average annual return.

Trying to invest short-term in the stock market gives you the same expected returns as long-term investing, but exposes you to more risk. It’s like paying the price for card A in the first example, but receiving card B. This is why many advisors recommend against using stocks for short-term savings/investment. It’s another way to see why people will accept a lower return in a short-term CD or savings account.

Desirability

I should mention another phenomenon that drives unequal expected returns—desirability. ESG stocks are a good example of this. A significant portion of investors desire companies that are more environmentally or socially friendly (ESG). For example, they may prefer to invest in a company manufacturing solar panels over a company drilling for oil. Higher demand causes higher stock prices relative to underlying business performance/fundamentals, and hence lower expected returns. Of course, if the population of ESG investors grows enough after you invest, their demand will further boost price and your return short-term gain (if you sell). The downside won’t be revealed until the number of new ESG investors drops below a threshold.

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