Intro – are risk and return related?
Marcus Schafer (00:05)
Hey everybody. Welcome back to episode 15 of Greenstream where logic meets life and investing. I’m Marcus Schafer Greenspring’s Director of Growth, and I’m joined by my co-host, Pat Collins. Today’s episode is about risk. One of the most fundamental components about investing is risk and return are related. Everybody understands return. Almost nobody understands risk. It might not be as much fun to talk about.
but it is probably more important to talk about. So we’re going to unpack what is risk. We’re going to talk about, as Pat mentions in the episode, why risk is not a four-letter word you need to avoid; it’s something that you should be thinking about. You should be thinking about how to mitigate it. You should be thinking about how to make sure you’re getting actual compensated return in exchange for that risk.
This episode is going to be about investor risk. We kind of think there’s two components of risk. There’s investor risk and that is whether or not your expected future profits are going to be realized. And then there’s also investment risk, which is, are you as an investor able to stick around for the ride to recognize that risk and turn it into return? So we’re going to come back in two weeks and we’ll be focused on.
investor risk, what are some of the behavioral traps that you might fall into. So of course, make sure that whatever platform you’re using, whether that’s YouTube or Spotify or Apple, you are subscribed. can also in the show notes, have a link to join our email list as well. So Pat, what were your top takeaways from the session today?
Patrick Collins (01:43)
I thought there was a few. the first is, that the right risk is good. And sometimes we think about risk as being a bad. we talked a lot about, you know, what, what’s the best kind of risk that you should be thinking about and taking. So that was, that was a key takeaway for me. Second was the dichotomies of risk. So compensated risks you talked about versus not getting compensated, balancing risk today versus tomorrow. We also talked about risk premiums.
which is something we’ve covered in prior episodes, but it really talks about what are the best ways or best chances, I guess I should say, of beating the market by taking different types of risk premiums. So we talk about that in pretty good length. How to understand balance and mitigating risks, the different types of risks, short-term, long-term, inflation, volatility. So I thought that was really good. I talked…
for a while about why didn’t invest in a pro soccer team and kind of the risk associated with that. And we use an example there. And then finally, we talked about some personal forms of compensated and uncompensated risk. So we hope you enjoy the episode and thanks for listening.
Marcus Schafer (02:57)
One of the oldest adages in finance, risk and return are related. Return, very easy to understand. Risk, not so much so. So I think that’s what we should talk about today, Pat, is just what is risk? What does it mean? What are the different forms it shows up in? So my definition of risk is uncertainty around future cash flows. I would love to know how you think about risk.
Patrick Collins (03:26)
It’s a really tough question because there’s so many different dimensions I think I could go here. But I would say for most of our clients when I talk about risk, it’s probably very similar to yours is maybe just put it in a little different way. It’s the potential that you won’t be able to achieve your goals. And it’s a fairly simple way to think about it. It’s less around the investment volatility and standard deviations and all sorts of different things like that. More just what’s the chance that you’re not gonna be able to do the things that you wanna do.
Marcus Schafer (03:43)
Mm-hmm.
Patrick Collins (03:55)
That to me is kind of that’s the way I think about risk.
Marcus Schafer (03:59)
Yeah. And it’s a, I think it’s tough to understand. And that’s why you see so many different definitions of risk. it like you mentioned standard deviation, which is just how much something goes up, how much something goes down. And you see all these differing perspectives simply because it’s really hard to say that’s exactly what risk is. It’s kind of like, Hey, we know it when we see it. But if you ask us in advance to tell you what it is, it’s a
It’s pretty tough. I think we’ll do our best job to talk about what it actually is. How does it manifest itself into different companies? How can you maybe define if something’s riskier or not? But we kind of have this simplistic explanation and honestly, it makes our jobs easier because when you’re explaining something to somebody, hey, that’s riskier and here’s the trade off. But what exactly is that? Is that risk?
Patrick Collins (04:50)
I think the other element that I would just throw in there is that it feels like risk is this kind of four letter word that these are things we should avoid. We should not take risks or that sounds risky. mean, it’s usually kind of in the terms of something bad. And I would maybe think after this podcast, hopefully people have an understanding of risk and how necessary it is.
Compensated vs. Uncompensated Risks1, 2, 3, 4 – just how ‘risky’ are individual stocks?
for us to be able to take risks. But I think hopefully what this will do is shine some light in the types of risks that are out there, the ones that you should be really looking at to not shy away from, and the others that maybe you shouldn’t be kind of diving head first into from a risk standpoint. So I think risk is not always a bad thing. And oftentimes it’s really what provides us for returns in the future, like you said, very early on.
risk and return are related, but you really need to understand what kind of risk are you taking because not all risk is good.
Marcus Schafer (05:49)
Yeah. Yeah. And maybe I’ll just pick up on the risk is good. Like we are where we are at as a society because people were willing to take risk. And even when you are not thinking you’re taking risk, you’re just taking a different type of risk. Right? So you kind of say, Hey, maybe I don’t like the risk of, think stock market investing is risky. So what are you going to do instead? You’re going to invest in cash that has a different risk. So we’ll dive into that.
But maybe let’s just start with kind of looking at what are some of the risks you maybe don’t want to take that maybe we’re not specifically thinking about. And if you look at companies, I think there’s a few different components to that risk of the future uncertainty of those cash flows. And it’s kind of like, what is the ongoing risk? I kind of think about this as opportunity cost risk, meaning
What happens if those cash flows go down by 10 %? That’s a certain type of risk. But then there’s also catastrophic risk, right? Which is, think about this, your boat sailing to go get goods from a different continent, there’s a risk that maybe your goods aren’t quite as valuable when they come back. There’s a risk that maybe you had to use more fuel or the wind conditions took you longer. There’s a risk to that that tends to be a little quantifiable. And then there’s also just, hey, what happens if a storm sinks your ship?
You can’t really predict that. can’t really forecast that. And that’s why one of the things we talk about most often is diversification because, hey, maybe you have one 10th of 10 ships. One sinks, you still have 90 % of what you had on the front end, but you’re diversifying away that single specific risk. And that’s something that you could do.
Patrick Collins (07:34)
I think about it as what risk do I take that I’m getting compensated for and what risk do I take that I’m not getting compensated for? And I think obviously when you hear that, you don’t want to take risks that you don’t get additional compensation for. maybe I’ll use hopefully an example to explain that concept. If I invest in an individual stock, what I would say is my expected return on that stock
I think most people would say, you ask them, what do you think the return on this individual stock is gonna be? Most people kind of look at the overall averages and they say, you’re expected to return on the stock should be about Now, with an individual stock, you brought up some things that come into play here, which is catastrophic risk. That company could go out of business tomorrow. Just in general buying one stock, the volatility associated with the returns of that stock are substantially higher than if I bought a basket of stocks.
And so I would consider individually investing in a stock, one stock, there is a tremendous amount of uncompensated risks that I get. That doesn’t mean that, you know, it might not get paid off. There is a possibility. It’s more, it feels a little bit more like gambling, which maybe we’ll get into in a minute. But then the other side of that is what’s the compensated risks that I get. Well, that’s really, if I, say I buy all the stocks, I buy the market, what’s my expected return then? It’s about the same. It’s about 10%.
The difference obviously is that the volatility associated with my returns over the next year, five years, 10 years, is gonna be much lower because I’ve diversified across lots of different industries and sectors and companies and whatnot. There’s not the risk of some one CFO cooking the books and I lose all of my money or there’s not some risk of some horrible government intervention that I could lose all or half my money or something like that, because I’m in the wrong industry.
So I think that’s an important thing to think about when you’re investing is, am I really getting compensated for this risk or is this just pure risk that is not really compensated for and the only way I’m gonna get paid out on it is probably more by luck than by just taking that risk.
Marcus Schafer (09:44)
Yeah. Yeah. The, when you look back at all the data we have and researchers have done this and they think about what is the actual most common, which means of all the stocks of all the years, what’s the most likely outcome for an individual stock? It’s that stock ends up going to zero between 95 % and a hundred percent loss. That is the most common outcome. And you look at that.
That’s super, super risky. mean, 95 % loss is practically going to zero. A lot of times people, well, I’m not buying those types of stocks, right? I’m buying large cap stocks. If you look back over like the last 30 years, on average, 13 stocks that were in the S&P 500 at some point in time have gone to zero, have gone bankrupt. Per year, 13 stocks per year. That’s a lot.
When you think about they were a great company that people had a lot of respect for, had a tremendous market value. And over the course of their time, were kicked out of the S&P 500 and ended up being kind of catastrophic losses. And that’s risky.
Patrick Collins (10:56)
I would encourage if you’re listening to this and you want to learn more about this, I would really encourage you to just look up the study. We can put it in the show notes by Professor Bessembinder at Arizona State, the one you’re referencing. The results are fascinating in the sense that how few individual stocks are there to create all the returns of the market. And so many stocks generate returns more like treasury bills,
or go completely bust and go near to zero basically. And so again, you think about that risk of compensated versus uncompensated. When you buy the market, you’re getting compensated basically for taking the risk of the market, but you no longer have that individual stock risks of, gosh, what if this stock goes to zero or something like that? Market doesn’t go to zero. So I think that’s something to consider when, this is just one of many examples of
compensated versus uncompensated risk, but it’s probably the best one that we see and the one we see most often is people buying individual stocks. You’re most likely not getting compensated for the risk that you’re taking. And we would suggest that you maybe read that study to learn a little bit more about kind of what history tells us about this.
Marcus Schafer (12:10)
Yeah, he had a follow-up study to that that I’m not sure you read, but it was super interesting and looked at the companies that contributed to the most wealth creation. What was the volatility of those companies? And as an example, Apple has had three drawdowns of 75 % or more, and that’s one of the largest companies today. So then there’s also this component of, do you really think that you have the conviction to buy at the beginning before it’s a
great idea before it’s a well-known company and ride through the super super volatile time. Another objection sometimes I hear is well that was in the past you know now these are better companies. Meta, one of the largest companies in the US, fell 75 % in 2022 three years ago. Since, AI has kind of brought us back but that’s a super super significant risk that’s a
There is again that word risk.
Short-term vs. Long-term Risks – by not taking risk, you might be taking a different type of risk
Patrick Collins (13:09)
Yeah. And you know, what didn’t fall 75 % was the market. The market obviously can have bad periods, but because of the diversification, you don’t tend to see that. So maybe we could shift gears a little bit. One of the risks that I talk a lot about when talking with clients is this idea that of long and short-term risk. And it’s a question that I think is really relevant for most
households when they’re thinking about the future. Most people, when they hear that word risk, what they’re thinking about is volatility. The fact that I could buy something and tomorrow it could go down and I could lose money, at least on paper. And that sounds risky to me. Anything that could go down 30 % or 50 % in a given year, that sounds really risky and that’s the stock market. And so what’s the best way, so I would consider that short-term risk.
the risk that it could go up and down or maybe more down in the short term. Now, what’s the best way to counteract that risk? Well, if I put all of my money in a checking account and I’m being obviously I’m taking the extreme here, but I completely negate that risk of short-term volatility because if I put a million dollars into a checking account, when I look at it tomorrow, it’s gonna be worth a million dollars. And then the day after that, it’s gonna be worth a million dollars and so forth. And so that’s the best way
to counteract this short-term volatility is use products or investment vehicles that have very low volatility or maybe no volatility. But when you do that, you bring in what we would consider to be long-term risk, which is the risk of outliving your money. And other people call that inflation. But basically every day that million dollars sits in a checking account, it is losing how much it can buy. So you don’t really feel it on a day-to-day basis.
but you do it over the course of a few years, all of a sudden your million dollars can buy 10 % less than what it could have bought 10 years ago. So how can I counteract this idea of long-term risk, which is inflation, this idea that goods are just gonna keep going up in price and I need to be able to keep up with that? Well, the best way is to invest in long-term growth types of assets because those assets like stocks tend to outperform
inflation over time or real estate or other investments like that. So this is kind of, this is the rub. And this is the thing that is hard for people to get is that by investing in such a way that I negate short-term risk, I bring into the picture long-term risk. And the other side of it is if I really want to outpace inflation and not have to worry about, you know, my, my funds not lasting, I have to invest in investments that bring a lot of short-term risk into my situation. So
part of the job of an investor or an advisor or the team working together is not saying one or the other is the right way to invest, but you have to figure out the mix. And the mix is going to determine, how much do I have in stocks that will help me outpace inflation over time versus how much do I have in this short-term types of investments that help me kind of sleep at night. And I now have these, I have both risks, how do I balance those? And in our opinion, the best way to do that, and we’ve talked about this in prior shows,
is you wanna be thinking about things like how much return is required for me to be able to do all the things I wanna do. For some people, ⁓ not a lot, but for some, this idea that you could put all of your money in a checking account and still be able to do all the things you wanna do. Some people can do that. They have enough wealth built up that they don’t need to have any growth on their money. It’s not common, but, most people even that have built that don’t wanna be that,
kind of frivolous, if you will, with their hard earned savings. They want it to grow somewhat. But anyways, that is a thing that you want to think about is what’s the right mix. So you need to think about what return is required. And then the other side of it is what risk or volatility am I willing to accept? How much can I see it go up and down? And that’s kind of, there’s a little bit of an art and a little bit of science to this to try to figure that out, what’s the right mix because…
More long-term kind of assets brings in more volatility. Can I live with that? That’s a question that you have to kind of figure out with your advisor. More short-term assets brings in the risk of me not being able to live the way I want to in the future, or maybe even outliving my assets. That’s a risk that you want to think about. So these are the types of risks that are probably the most important in my opinion for investors or for households is thinking about how do I balance short and long-term risk and how do I invest accordingly then?
Marcus Schafer (17:39)
Yeah, and the short-term risk, I think here in the States, we’ve kind of been very fortunate relative. like right now, you could go get a high-yield savings account, 4%. Well, let’s just walk through what that really means. 4 % in a taxable account, that’s interest, so it’s taxed ordinary rates, call it 25%. So you’re left with 3 % after tax. Latest inflation.
reading that just came out, 3.1 % for the core. Okay, so you’re actually at a negative 0.1 % in, historically for the US, a low interest rate environment, a low inflation rate environment, and historically compared to the rest of the world, pretty favorable ⁓ inflationary type environment. So the best you’re doing, and kind of the best case scenario, is barely keeping up
with inflation and you’re not thinking about what could potentially happen down the line. And then you think about the investment time horizon, which in a lot of cases as health expectancy is improving, as people are making great choices, that’s getting longer. that’s kind of like, on one end you have that risk and then you have the risk we started with, which is somebody buying individual stocks. They’re way too risky, not enough.
risky from the conventional risk and return are related perspective. Figure out how to balance those, make sure it’s personable. And both are significant. It’s really hard to figure out which one is more impactful than the other. But to your point, this is like the most important decision in finance. It’s figuring out how do you balance those two objectives, take the right risk, the right amount of risk, so you could stay with it.
Patrick Collins (19:29)
And I would maybe throw another component into this, hopefully, as people are listening to this, as they’re thinking about these two risks. I think time, you mentioned this a little bit, time has a big element on how much risk you should be willing to take. again, I’m gonna use some extremes here, but if my time horizon is one month, meaning that I’m gonna need to access my money in one month from now.
you want to look at least at history to give you an idea of the risk associated with putting your money in growth types of investments after some certain periods. But let’s use a month. It’s about, it’s a little better than 50 50. If I were to buy stocks that one month from now, I will have more money than I started with. It’s about 55 45 or so. And so when you think about
those stats, that doesn’t sound like great odds to me. If I am a, if I’m a betting person, I’m not gonna, I’m not gonna bet my life savings that I’m gonna have more money. Because the thing about that, too, is if I’m wrong, it’s not like I might be wrong by a little, but I could be wrong by a lot. And I might need that money a month from now. So time is kind of your ally. If you have time, you can take more risk. You can take, you have more invested in those growth assets.
because the longer you go out, the lower the probability, at least historically has been, that there are losses associated with kind of those growth investments. So if I invest for 10 years, I’m gonna be looking more like about 90 % of the time, I’m gonna have more money 10 years from now than I started. That’s way better than my period of one month. It’s a little bit better than 50%. So, the younger that you are,
the more time that you have, you probably have the ability to take some more risks because that risk is gonna show itself in being compensated to you through higher returns. And that’s the one thing about risk. Risk and return are related. And I think a lot of people kind of know that intuitively, but they think that risk means return. And it means expected return. It doesn’t mean actual returns. We don’t get that all the time. That’s the reason it’s called risk.
is that sometimes we get way worse than what we expect. And so again, the longer that you have, when you take that risk, yes, you’re gonna have that short-term volatility that you’re gonna be able to, you’re bringing into your situation, but you can be a little bit more confident to say that I can ride this out because I have 10 years. If I have one month, I can’t ride this out. I need this money a month from now. So I think that’s another element to think about when you’re building a portfolio, figuring out how much risk to take.
part of that should be your time. How long do you have before you need to access this money? And the one other caveat I would just put on that, because sometimes we’ll hear clients say, well, I’m 60 years old. I don’t have any time. Like I’m retiring in five years or I’m retiring in two years. That may be true for just a small portion of your money, but you need your money to last. If you’re 60, you probably need it to last for 30 plus years. So you may not think about it that way, but…
Some portion of your money, yes, you shouldn’t be taking a lot of risk on because you need to access it fairly quickly. But the assets that you might need to spend 20 years from now, you probably have the ability to take a little bit more risk with that because you have time.
How Much Diversification Is Needed5 – 250+ large cap stocks and less than 10% of your portfolio in any single holding
Marcus Schafer (22:50)
Yeah. And when you say risk again, it’s compensated risk. So that means systematic risk, not idiosyncratic. That’s kind of the single company risk. and one of the things I see oftentimes is let’s say you’re doing a baseline projection, retirement projection. How much money am I going to have at retirement? How much money am I going to have through retirement? You need to use assumptions. Well, those assumptions you’re using are the systematic.
risk assumptions. They’re, hey, 10 % expected return, 15 to 20 % volatility. What changes is if you’re not fully diversified, you actually need to use those, change those assumptions. And so it’s going to take your probability of success over the long horizon. It should bring it down if you’re using the historical numbers that somebody like Bessembinder is finding, right? So you should be saying, hey, my volatility is much more than
That’s going to change my range of outcomes very dramatically. So I guess maybe the question is, what is the right amount of diversification where you’re switching from uncompensated to compensated risk? So I guess that’s my question for you. How do you think about…
Patrick Collins (24:05)
Yeah, that’s a great question. think I’ll just say how we talk about it here is that we don’t see the downside for taking more diversification than less. So I know there’s lots of studies out there that say, oh, once you hit 50 stocks or 100 or 250 or whatever the number is, you should have a representative sample of the broad market and you should be fine.
Innovation is at such a spot now where you can invest in essentially almost every publicly traded vehicle that’s out there. And we don’t see the downside to that. We just think further diversification is better. I think there might be elements that we’ll talk about that you can make changes to enhance your potential returns, but not through us trying to pick the best 50 or the best hundred. I think as soon as you start thinking about, well, I own 30 stocks, that’s enough.
It probably isn’t. All it takes is getting a bunch of those wrong, which Professor Bessembinder talks about how easy that is because of the numbers. think you probably, if you believe in this idea of compensated risk and trying to make sure you invest that way, we would recommend buying market, of entire markets instead of trying to 50 stocks or 100 stocks or even 200 stocks.
Marcus Schafer (25:27)
Yeah, it’s trying to figure out what is that limit. I think I remember, and this is, I couldn’t find the sources for either of these two points, but taking for a grain of salt. I think I remember a decade ago when I was studying for the CFP, there was like a test question, practice question that was like, what is the level of diversification in large cap stocks? And the answer was 25 to 35. I think I remember this, the other one that’s a
Bill Sharp, could have been Mark Witts, They asked what one of their biggest mistakes was, and it was this chart that showed that the benefits of diversification die off at 41 stocks. That was a big point as well. And then you look at some of the more recent research, and it maybe says about 250. Again, these are large cap stocks. So if you’re anywhere outside them, you need way more than this.
where you’re getting enough diversification to really start switching this to be a systematic risk perspective. then what you’re saying, Pat, is, if the US market gives you 3,500 stocks, you’re going to have to really argue hard why you don’t want 3,500. And there’s good reasons why you don’t want quite that many, but you definitely want to be leaning more towards that than 250, based upon the evidence that
We’ve seen. Another way I really think about risk is what is your position sizes relative to what the market is saying is a nice risk adjusted holding weight. So if Apple is 5 % of the portfolio and you own 50 % of your portfolio is Apple, you did a 10 times market cap overweight. That means you took a massive bet.
that Apple is going to keep doing as good as it’s done in the past. And what you’ll find when you go through that lens, I think people, you discover you’re taking more risk than maybe you intended to once it’s relative to something, but it’s just really tough to see, see an isolation. I would, I would for sure say if something’s at 10 % of your portfolio and above, no matter what it is, it’s probably too much, too much single, single exposure.
Patrick Collins (27:50)
Yeah. I, know, early on, someone told me this and it’s always stuck with me is that you, ⁓ you, you make your money through concentration and you protect your money through diversification. And if you look at all, you know, you look at the Forbes list, it’s people that have taken tremendous risks because they’ve concentrated their assets and it’s worked out for them. And I think that means everybody thinks that that’s how they should do it, but that’s worked out for them. What’s not shown is the Forbes, you
whatever the people have lost all their money, they don’t make a list of them, but people that have tried to put all their money in one asset and have lost it all. So not to say it doesn’t work out, but you make a really good point there that the size of your portfolio, your positions in your portfolio matter a lot, not just owning 500 stocks. If 499 of them were 0.001 % of your portfolio and one was,
90 % of your portfolio, there’s 490 stocks, 99 stocks don’t matter. So thinking about the position, the size, that does matter for sure.
Marcus Schafer (28:48)
Yeah.
Well, and one of the things I guess I take issue with when it’s this, hey, you build money through concentration and you keep it through diversification. What people mean is businesses that you can influence and change. And this is my big gripe with what’s called active management is I’m not really sure how much influence they have on companies and companies decision. That’s activists.
So when somebody says, hey, build money through concentration, show me the list of billionaires that bought a single security, had no involvement in the running of that, and watched from the sidelines and became very successful. That list is much smaller. It’s much less prestigious. So again, it’s kind of…
Patrick Collins (29:41)
I honestly don’t
know. I don’t think I could name one that didn’t have influence. I’ve been doing this now for about 25 years. I’ve had one client in my entire career that had made their wealth through picking individual stocks. And it was a pure luck situation, but it is so rare that that happens. I think you make a great point, this idea of.
concentration tends to be in an asset or an investment or a company that you are directly controlling and have a pretty big influence over. So I think that’s really, really important. Moving to, you know, thinking about this idea of compensated risk. Obviously we’re talking about this idea of, well, invest in a basket of stocks instead of an individual stock, you’ll get compensated for that risk versus maybe the uncompensated risk you’re taking here.
The Market Premium – the highest risk adjusted returns come from investing cash
But there’s probably some other areas of the market that we wanted to talk about that we believe you get compensated for by taking some additional risk. And this is helpful when you’re thinking about building a portfolio, which is, if I’m adding an asset or I am overweighting something over another, am I going to get compensated for that? And so probably the easiest one that I think about, and we’ve talked about a little bit already, is this idea of
the stocks versus bonds. That is a compensated risk. When you have a bond portfolio and you add stocks to it, you are most likely adding some risk to your portfolio, but you’re getting compensated through that, through higher expected returns. most people understand that intuitively, I am taking more risk than I would in a bond, and I’m getting compensated for that risk.
Again, how you invest in those stocks matters. If you are investing in one stock, I’d be careful. If you’re investing in a index or a basket of stocks, yes, you’re probably gonna get compensated over what you would earn in a straight bond portfolio.
Marcus Schafer (31:42)
Yeah, and the best risk adjusted returns you can find out there in the marketplace is every incremental step up from cash, from the cash in your pocket to, hey, you can essentially 10 times the return, you make zero in your pocket, you put it in a bank checking account, you get 0.1%. Okay, now you could think a savings account, okay, you get 0.25%. Okay, a high yield savings account, you can get all the way up to
4 % by the way that’s still insured so it’s that’s pretty amazing then you can think about well what if i just take a little bit more risk from a high yields savings account wow like money market funds a little bit more you’re taking a little bit you can kind of go some of these ultra short [bond funds] so that part of the yield curve just going from cash to getting it invested
That’s your highest risk adjusted returns out there. And a lot of times, you know, somebody’s coming in, they’re saying, Hey, I’m looking to increase my return. Well, I have a hundred thousand dollars. I’m waiting for the best, the next best idea for what to invest in. Well get that into the market while you wait. You know, that’s the easiest spot to get your return. this part of this market premium stocks responds. This is absolutely.
one of like, you gotta get this part first before you get to any of these other things I’m sure we’ll get into.
Patrick Collins (33:15)
Yeah.
One of the things I always found fascinating with risk and return, we’ll keep it at a very high level between stocks and bonds, is I think the intuitive thought is that if I have a portfolio of 100 % bonds and I start adding stocks to it, I am incrementally adding risk to the portfolio. So if I add 10 % in stocks, I have 10 % more risks now associated with the portfolio, 20%, 20 % more risk and so forth as it moves up. In reality,
Marcus Schafer (33:33)
Mm-hmm.
Patrick Collins (33:42)
it actually doesn’t happen that way. What you find is, and it depends on the periods that you look at it, but as you add stocks to a bond portfolio, the risks actually doesn’t change. It stays about the same until you hit 10, 15-ish percent in stocks, and then the risk starts to increase. So how is it possible that adding stocks to a bond portfolio could actually keep the risks the same? And the main reason there is this, you know,
You probably don’t wanna get too deep into the weeds on these finance terms, but it’s this idea of, or math terms, correlation. And so whenever you put 100 % of your money in one thing, there’s always some risk associated with that. So if I put it into bonds, I have the risk that rising interest rates could cause my bond prices to fall. So if I’m looking at adding stocks to a portfolio,
Is it possible that when one thing is going up, something else could be going down or vice versa. They could be zigging and zagging at the different times. And even though one has a lot more volatility, just by adding a little bit to it, the fact that they aren’t correlated together, meaning that they’re not working together and working kind of lock, stop, and you know, whenever something happens, it can actually keep the same or even lower the risk of an overall portfolio. And so that’s something to think about as you’re building a portfolio is,
Am I adding an asset that’s going to behave the exact same as the other assets in the portfolio? Or is it going to behave totally differently? And you think about stocks and bonds, what hurts bonds is rising interest rates. Well, why do interest rates rise? Well, a lot of times it’s because there’s growth in the economy that we want to kind of maybe potentially tamper that down with rising interest rates or raising interest rates.
When you think about that, it’s like, well, if rising interest rates hurts bonds and rising interest rates typically comes when there’s high growth in the economy, maybe stocks do okay during rising interest rate environments. And in some cases we find that they do. So, that’s the thing is that we have two assets then that aren’t zigging and zagging at the same time. And that can really add value to a portfolio because it’s kind of what the old adage is the only free lunch and investing is diversification. And this is an example of that.
is that you can put two assets together, have a higher expected return and not really take any more expected risk because they’re not correlated. So hopefully that makes sense, but I think that’s a really important point as you’re building portfolios is can you find assets that don’t behave in the exact same environment, the exact same way.
Marcus Schafer (36:12)
Yes, and the one thing I’ve… When you first learn about this, kind of… It makes you think, when something goes up, I want something that goes down. But that’s like inversely correlated. A lot of times, it just doesn’t have to be perfectly correlated to make a difference. So you still want two assets that go up over time. Very important. You just don’t need them to go up at the same amount in the same way. One goes up 10, the other goes up 4. That’s still very beneficial.
for your portfolio, especially if you have a systematic plan to rebalance between the two and stay on kind of what we talked about towards the beginning, which is the right risk tolerance for, when things go south, can I still be okay?
Patrick Collins (36:56)
Yeah, it’s a great point. Yeah, if they work completely opposite of each other, then it’s like, what are you doing here? Because you have one going up and one going down, they’ll cancel each other out. So it’s a great point that you just don’t want them to be dependent on each other, basically, that they go up and down at the same rate, but you want them to both go up. Just maybe the pattern of their returns will look a little bit different. moving on to some other kind of what we would consider compensated risks.
Risk Premiums6, 7, 8 – the best odds of beating the market comes from taking different forms of compensated risks between stocks
would be, and I think this is the world where you came from. So I’d love to ask you, you know, some of the, some of the research that’s out there, some of the thought around it, but it’s the, lot of the research that was done in the eighties and nineties around things like size of company. So, small companies have historically had higher returns than large companies, but they’ve also been found to have higher risk associated with that. And so,
And then there’s others, there’s companies that have a high price or a low price relative to something like their earnings or their book value, have had higher returns and higher risk relative to kind of their counterparts that have a high price compared to those earnings. So what’s going on with that? Maybe you can talk a little bit about the research and how we should be thinking about that when we’re building portfolios.
Marcus Schafer (38:15)
Yeah, so it builds off of everything we’ve talked about, stocks versus bonds. Almost everybody out there will tell you, yes, stocks are riskier than bonds, and they deserve a higher expected return as a result of that, right? There’s, hey, stocks have expected future cash flows, bonds, there’s a promise they’re going to repay you that face value. They’re going to pay a coupon. There’s a different level of uncertainty around those cash flows. So what the researchers have done is that
Well, why can’t we take this idea and expand it to differences between stocks and differences between bonds? And most of these ideas are super widely accepted in the literature and practice that, yeah, you would think, hey, small companies are going to be a little riskier. There’s probably some additional uncertainties to their cash flows compared to somebody like Apple. There’s value, which means if
You pay a price that’s lower relative to what you get, whether that’s future profits or the company’s properties. That tells you something about the riskiness and if risk and return are related and you can get enough diversification, you should have higher returns. I think something very important is a lot of people look at the difference. So they’ll say, what’s the difference between a large company and a small company is 4%.
But nobody’s suggesting you only go buy small companies, right? So the magnitude’s less impactful than getting that stock bond decision right first, but still very impactful to try and understand what type of characteristics of stocks tell me about compensated risks. There’s probably five or six real ones, but there’s about 300, 400.
that people have found in the literature, turns out to get a PhD, you have to find something interesting. So you come up with a new factor. They all kind of relate back to one of these original size value profitability. Reinvestment is kind of a newer one, but those are the compensated risk factors amongst stocks. So you can look at an individual stock, it’s a relative to stock that’s its peer.
if it has higher profits, there might be a risk associated with that.
Patrick Collins (40:37)
It’s explaining this to kind of clients. I sometimes tell a story and it was one I’ve been thinking about here. ⁓ Years ago, I was approached to invest in a like a local sports team. They wanted to bring a professional sports team to they were trying to bring an ownership group together and they had a whole package on it. And I looked at it and I kind of did the math on what I thought the expected return was going to be.
And it looked like it was going to be about 10 % for them, whatever capital they needed to raise to build a small stadium and hire, and they had payroll. It was a small kind of soccer franchise thing. And so I started thinking about it, obviously. And I realized that it’s the same kind of expected return I’d get for investing in, let’s just say, Apple, to your point.
If I want to use a big company, I’ll use this as my small company example, because it’s a very small, it was basically non-existent. So if I was going to put my money into something, and in both cases, I was going to earn a 10 % return, you know, it didn’t take me very long to think about which should I invest in? Because while it would be cool to say you’re an owner, and my guess is that’s why they didn’t, they priced it a certain way.
The reality is if I cared about my returns, I would put it in Apple because again, we’ve talked about that being uncompensated risk, but just purely from the standpoint of trying to compare two things, Apple has a much higher likelihood of being around even five years from now than this company, this team was gonna have. And so now if that team had come to me and said, you know, we know this is risky.
this is gonna be a tough thing to try to raise capital for. We’re gonna offer, we’re gonna price it in such a way where we’re gonna offer 20 % returns for you if you were to invest in this. I might’ve thought about it a little bit more. Maybe the others, it never came to fruition, so maybe more investors would’ve thought about it some more. ⁓ Because now I can kind of do a comparison to say, well, large companies I know that have been around for a while.
Marcus Schafer (42:30)
Haha
Patrick Collins (42:43)
the average large cap stock earns about 10%. The only way for a small company like this or a startup is to attract my capital is to offer way higher returns. Cause you know what? There’s a way more risk associated with this. This thing could be gone in a year and all my money could be lost. I need to get compensated for it. So I think that’s really why small companies have higher returns or you would expect them to have higher returns at least over time. And they actually have over the last hundred years or so.
is that they have to, know, investors demand higher returns on their money when they take more risk. Why else would they invest in anything like that? So I think it’s important to think about, you know, why you said, why, know, if small companies have had higher returns than large, why wouldn’t we just put all of our money in small companies? Well, for the reason I mentioned is that small companies have a lot of risk associated with them. And, you know, you just want to be very, very careful about that. Now, as an investor,
If you said, really want to outperform the market, the ways we, you know, what are the ways I could go about doing it? What we would tell you is don’t go pick individual stocks. There’s nothing that tells us that you’re going to, that’ll be pure luck if you can do it and good luck if you can, but there’s nothing out there in the evidence and the research that says that just by picking stocks, you’re going to have a higher, you know, possibility to outperform the market. This is an area for investors that do want to take more risk.
to think about, which is how much do I put in my portfolio of large companies versus small, low price stocks relative, let’s say to their value compared to high price stocks, how much do I weight those? That’ll have a determinant, hopefully on my expected returns. Doesn’t mean it’s always gonna play out that way, but it gives me probably a fairly decent chance through a compensated risk to earn higher expected returns.
Lottery Stocks9, 10 – it is difficult to find stocks that beat the market, but in this case, easy to find stocks that lose to the market
Marcus Schafer (44:34)
Yeah, you’re well, bummer that Baltimore, Maryland doesn’t have a soccer team. Now, I guess we know where to submit our complaints to. But the story you told is actually an interesting example of supply demand and what I would call like lottery ticket type investments or trophy asset type investments. So we said that small companies have higher returns than large companies and
value companies have higher returns than growth companies. Well, something that puzzled researchers for a really, really long time is why does US and international emerging markets small cap growth suck so much compared to our expectations? Because you’d think growth, lower returns, small higher returns, maybe those kind of cancel out. And then you look at the returns and it’s way below your expectations. And so a lot of research is kind of trying to understand
what’s going on with these companies. And earlier I said, there might be good reasons why you don’t want maximum diversification. I think this is probably the leading reason is sometimes you find these weird market dynamics. So what’s kind of going on behind the scenes is you have these small companies that are very expensive because their price is high, but they really don’t have profits. A lot of times they don’t have any revenue.
kind of find this a lot in small caps. Companies are not profitable, but they don’t have any revenue. They have to reinvest a lot just to keep their business going. And when you look at the returns of those types of companies, it’s actually about the risk-free rate. So you’re getting about 30 % volatility, but your returns are the risk-free rate. So you should certainly, every time you’re investing,
Start with max diversification and then think about amazing reasons why you would want to walk away. Now, part of the marketplace in terms of market cap, that’s just about 2 % of the US market cap. And it’s pretty true outside the US as well. But this is kind of this trophy asset. That’s where a lot of people are going to try and pick individual stocks. Why? Because if you hit one company, a lot of these are like a
It used to be like biotech, right? You’re waiting for the FDA approval. And if you get it, stock price jumps. Unfortunately, most of the time, you might not get that catalyst or you might not be able to bring it to market. So avoiding this temptation to chase like these lottery type, these trophy assets is making sure you’re not, you know, you’re taking systematic, not uncompensated risk.
Can You Beat Expectations? 2, 3 – high expectations means high hurdles to clear and high incentives to disrupt
Patrick Collins (47:14)
Great. I guess one of the, maybe even shifting gears a little bit more, one of the things I was thinking about as we were talking about this concept of risk is how does risk manifest itself? How do you see it? Like when you’re looking at investments, how do you know, is this stock risky? Is it not? How does the market perceive it to be from a risk standpoint? And it got me thinking a little bit about price and how price really does
kind of tell us a lot about how much risk a company, or at least investors think a company has. So you think about companies that have a lot of uncertainty around their earnings. If that’s considered to be risky, those earnings could maybe not be there next year, or could be maybe really struggle, or maybe they’re just not growing at all. And people are just like, this is a risky company. They can’t seem to grow their earnings. What happens? Well, the price comes down.
on that investment typically. And so, you know, that now it’ll look like, you know, obviously this is a great investment because it’s got a low price relative to its earnings, for example. But that’s because the market is perceiving that to be risky because there’s something going on there that they think those earnings may not continue. They may fall. They just may not grow. The other side of that is the companies that are growing really, really quickly.
And people have a lot of certainty around the fact that these are gonna be companies that are gonna be around for a long time. They’re gonna have great prospects. You think about like Amazon today would be a good example of that. People are willing to pay really high prices for their earnings because they don’t perceive them to be that risky. And I just find it really, really fascinating. First off, what data tells us in history is that the low price stocks, the ones that have, they’re perceived to be risky in the market, or at least their earnings perceived to be risky,
they’ve had higher returns in the high price stocks over time. But what’s interesting to me is if that trend continues on the high price stocks, the ones that the market is saying, this is gonna do really well, we’re willing to pay high prices for these earnings, I wonder if at some point that creates its own level of risk where things just keep going up and up and up. And all of a sudden, there’s a lot of risk that those earnings have to
hit this really, really significant bogey to be able to continue the justification of this high price. So I don’t know, do you have any thoughts on that? It was something I was thinking about is like, can low risk lead to high risk over a period of time because of the complacency that happens and that people start to expect more and more and more out of it because it’s always delivered and it’s considered low risk that it won’t deliver. And then all of sudden when it doesn’t, now,
is there much higher level of risk because the price, there’s no margin in that price anymore.
Marcus Schafer (50:04)
Yeah, yeah. think there’s two components. One, the market is a game of expectations. So I’ll maybe talk about that. And then two, anytime you have big profit margins, that creates incentives for new entrants. I’ll maybe talk about that. But the market’s game of expectations. A lot of times, if you’re thinking about the stock market,
Probably not the best to use a gambling analogy, but do we think the Ravens are going to win their first game? We do. They’re a pretty good team. They’re amazing. Whoever they’re playing, we think the Ravens are going to win. That’s not what the market’s about. The market’s about, hey, are the Ravens going to win by 14 points? Okay, well now we just entered into a completely different argument. So it’s about, you meet these expectations? And when you think about these high-flying growth companies,
there’s really high expectations that they have to meet just for their stock price to be justified, but they have to exceed for it to go up. Well, with the value companies, the expectations are a lot lower for them to meet and exceed. So what we’ve seen is value companies tend to, when you compare the returns, they tend to do better. Maybe it’s because the expectations are easier to meet. And then kind of the second part was just about
You have this big profit margin. Are you creating an incentive? When we were looking at some of the research around why are some of these good companies having these catastrophic events? And sometimes you see good companies events. A lot of these events are outside their control. So it’s really tough to say, hey, this management team did a terrible job. They didn’t do it. But one of the interesting things is sometimes people inside those companies
had the great idea. They’re like, man, this company is missing something. So what do they do? They go start a startup and then they compete against their old company. They got all the inside knowledge, but instead of innovating inside of that organization, they see the opportunity outside of it. So there’s just these weird incentives. And this is why there’s premium for profitability companies with higher profits compared to companies with lower profits. Well,
there’s a chance those profits aren’t going to continue. And so you have to think about how do you build that into a portfolio? But yeah, there’s real reasons. And a lot of times these reasons are not like they’re bad companies. That tends not to be the reason. It tends to be something outside of their control.
Patrick Collins (52:40)
Great. So I know we’re kind of coming up on the end of our time here. Do you have some takeaways that you would as a, investors, we’re talking about risk today. What were some of the things that you would kind of leave investors with in listening and when you’re thinking about the risk associated with their portfolio?
Risk is Pain When I’m in Pain – diversification is a solution
Marcus Schafer (53:00)
Yeah, I would say another definition of risk I’ve heard pain when I’m in pain, kind of what that means is, if the world’s really tough and my portfolio really sucks at the same time, that is super, super risky to me. And then what I hope people get out of it is individual securities are more risky than you probably think. And what you can easily do.
is add diversification. And I was talking with somebody earlier this week and they were saying how they’re invested in individual securities. They know they’re going to get some bad outcomes, but they’re also aiming for the high outcomes and they’re trying to increase their return that way. And what I would just encourage people to do is instead of thinking about a concentrated individual stock portfolio where you’re doing that mentality,
get diversification, actually narrow your range of outcomes, it’s gonna create a more streamlined, robust return experience over time. But the evidence shows us that’s a better path forwards than trying to kind of barbell your approach to have a few winners, but understand you’re gonna have a few losers, because when you look at the Bessembinder research, there’s gonna be more losers than there are gonna be winners. So I’m not sure the math’s gonna work out if you don’t happen to get that.
that one winner.
Patrick Collins (54:25)
Great. Yeah, I totally agree with that. think there’s two things I wanted to maybe leave with that I took away. One is kind of going back to this final concept of short and long-term risk and thinking about that as an investor. How do I counteract that? How much of my portfolio should be allocated to investments that will help me mitigate short-term risk, which means that I’ll have it in safe investments that won’t go up and down much. And then how much of my portfolio do I put in long-term investments?
that are gonna grow and outpace inflation. Both have risks associated with them, but both also serve a purpose. So thinking about that, that’s gonna be partly based on your time horizon, the tolerance that you have, the requirement you need as far as what you need to earn. Those are all things to kind of factor that in. A good advisor really does, should help you think through that. The last thing is gonna be a little bit more personal. And it’s something I was thinking about as we were thinking about this idea of risk. And it’s really,
Risk is Not a Bad 4 Letter Word – taking risk for investment and personal purposes has benefits
hopefully an encouragement for people to think about taking risk in their lives. I think about all the good things I have in my life and they’re all from a risk that I took. I think about this business, Greenspring, was solely a risk that I took to leave a big firm and start this. I think about my marriage.
I took a risk to ask my wife out and I didn’t know if she would say yes at the time, but it felt risky. can tell you that, whatever it was, 25 years ago or so, to ask her out. I even think about my kids. It felt kind of risky at the time to have kids. I had just started this business. We didn’t really have a whole lot of income. And I look back and I don’t think I’m naive enough to think that all risks always work out.
Marcus Schafer (55:52)
Haha ⁓
Patrick Collins (56:10)
But I do know that all the good things that we tend to have over time is because that we were willing to be a little bit uncomfortable. We were willing to take a risk. And so obviously that applies to our portfolio, but I think it applied to our lives too. So just want to encourage everybody, don’t be afraid to take risks.
Marcus Schafer (56:25)
That’s a great ending and just think about the risk that Beth had to take. Yes. And then, you know, make it back to the point about compensated versus uncompensated. If we ever see you in a mustache, is that a compensated or uncompensated risk, Uncompensated. Okay. All right.
Patrick Collins (56:30)
When she said yes, exactly.
I feel like that’s gotta be uncompensated, but I don’t know.
Sources:
1 Do Stocks Outperform Treasury Bills? by Hendrik Bessembinder :: SSRN https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2900447
2 JP Morgan’s The Agony and The Ecstasy (2021) https://privatebank.jpmorgan.com/nam/en/insights/latest-and-featured/eotm/the-agony-the-ecstasy
3 JP Morgan’s The Agony and The Ecstasy (2024) https://privatebank.jpmorgan.com/nam/en/insights/markets-and-investing/ideas-and-insights/the-agony-the-ecstasy
4Extreme Stock Market Performers, Part I: Expect Some Drawdowns by Hendrik Bessembinder :: SSRN https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3657604
5 Petajisto, Antti, Underperformance of Concentrated Stock Positions (June 30, 2023): https://ssrn.com/abstract=4541122
6 Fama, Eugene F. and French, Kenneth R., A Five-Factor Asset Pricing Model (September 2014): https://ssrn.com/abstract=2287202
7Harvey, Campbell R. and Liu, Yan and Zhu, Caroline, …and the Cross-Section of Expected Returns (February 3, 2015): https://ssrn.com/abstract=2249314
8 The Three Ways To Beat The Market | Greenstream #2: hhttps://youtu.be/XeGNGWNbF-8
9 Asness, Cliff S. and Frazzini, Andrea and Israel, Ronen and Moskowitz, Tobias J. and Moskowitz, Tobias J. and Pedersen, Lasse Heje, Size Matters, If You Control Your Junk (January 22, 2015): https://ssrn.com/abstract=2553889
10 Rizova, Savina and Saito, Namiko, Investment and Expected Stock Returns (July 8, 2020): https://ssrn.com/abstract=3646575
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