This chapter addresses the investor’s common question in an uncommon way: How do I weigh the risks and rewards of investing in equities (stocks) versus fixed income (bonds)?
It also addresses other questions that are not on everyone’s mind but should be. How is investing different from speculation and risk different from volatility? Can volatility be an opportunity instead of a threat?
Spooked by the financial crisis of 2008, many investors have shunned equities due to their volatility and instead embraced bonds for their stability. My contrarian point of view is that not only could this bring disappointing returns, it may actually prove riskier.
Investing is Not Speculation
The key difference between investing and speculation is how the odds are set. In speculation—gambling—the odds of winning and losing are preset. You win or lose by chance, not choice. In investing, you have the power to alter the odds, if you are willing to do the work. This means you win or lose by choice, not chance. This is a crucial distinction. If you play an active role in investing, you can influence the outcomes through skill. In speculating, you are reduced to a passive position where luck prevails, and skill does not matter.
“In investing you win or lose by choice, not chance.”
There are primarily two elements you need to consider when making an investment: the risk it exposes you to and the reward you can expect from it. You should always insist on knowing the odds of making or losing money in any investment proposition. To do that, you start by understanding the true nature of risk and reward. That is the purpose of this chapter: to help you pull apart some common misconceptions and see the risk/reward balance with clarity.
What exactly do those two words, “risk” and “reward,” mean? I think of risk as the potential for permanent loss of money, and reward as the compounded rate of return over a full market cycle, typically ten years or more.
This leads me to address a big question that should be on everyone’s mind: Should I invest in stocks or bonds? Which give the better returns? Which have lower risk?
Fixed income (bonds) and equities (stocks) are core building blocks of any investment portfolio, but they have vastly different risk/reward profiles, and determining the right mix between them is the most important decision you can make. Conventional wisdom would have you believe that bonds are low return but also low risk, while equities bring high return but with high risk. Unconventional wisdom suggests that bonds may actually be higher risk and stocks may be lower. Let us explore the risks and rewards of both, so you can choose between them with eyes wide open.
Investing in Stocks: Risks, Rewards, and Volatility
The “Nasdaq Crash” of 2000–2002 and the financial crisis of 2008 knocked the wind out of the sails of many investors, seducing them into the presumed safety of bonds and scaring them away from the apparent risks of equities. Indeed, bonds are so coveted that even junk bonds (those rated below investment grade, implying they are riskier) are venerated as high yield.
It is a tragedy that there is an entire generation of investors who do not appreciate the rewards of equities and instead singularly fret about their risks. At the same time, they display an unhealthy predisposition toward bonds and an underappreciation of their risks.
There is an important corollary about equities. Many investors shy away from them because they misunderstand—and therefore mistrust—their volatility. Volatility is not the same as risk; in fact, volatility can work in your favor, as we shall see shortly.
Rewards of Equities
Equities offer something that bonds simply cannot: the greatest opportunity to make a lot of money in the long run. It is true that bonds offer the greatest opportunity to not lose a lot of money, but that is not the same as making a lot of money. The top-ranked billionaires of our generation, such as Warren Buffett, Bill Gates, Sam Walton, and Jeff Bezos, all made their billions owning equity—in Berkshire Hathaway, Microsoft, Walmart, and Amazon, respectively. More impressively, they did this in a single lifetime.
Please do not think I mean you need to be rich to invest in equities. In fact, the best part of equities is not just their ability to build wealth, but that they offer that opportunity to anybody. Whether you are a blue-collar or white-collar worker, young or old, male or female, black or brown or white, upper- or lower-income bracket, you can get a piece of the action—by, for example, owning equity mutual funds—for as little as $1,000. Equities are an equal-opportunity asset class. In addition, you can invest in equities on any day or every day, regularly or sporadically, with a big or a small amount. Nothing is more flexible and inviting than that. There is really no excuse to not join this club.
In fact, if you want to make your money work as hard for you as you have worked for it, few things beat investing in equities in the long run. Notice I said, “in the long run.” To understand the risk/return profile of any asset class, whether equities (stocks) or fixed income (bonds), you must look at a horizon that equals life spans, not quarters or years or even decades. Seen through that lens, equities have beaten bonds handsomely. Figure 3.1 illustrates this difference: the greater the allocation to equities, the larger your returns—by a factor of 2. If history repeats (there is no guarantee that it will), a nest egg of a million dollars, invested in stocks, would have earned an extra million dollars. Differently put, not owning equities is like potentially leaving a million bucks on the table.
FIGURE 3.1 Best, worst, and average returns for various stock/bond allocations, 1926–2016. Source: Vanguard Fund, “Vanguard’s Principles for Investing Success,” figure 5, https://personal.vanguard.com/pdf/ISGPRINC.pdf.
Remember that equities have performed well over periods that spanned some truly trying and terrifying times—through war and peace, terrorism threats and espionage scandals, trade wars and trade pacts, loose and tight monetary policies, inflation and deflation, boom and bust years. Equities know how to scale a steep wall of worry.
Volatility of Equities
The biggest pushback on equities is that they may offer higher returns, but they also come with higher volatility.1 Their prices swing wildly, changing a lot in short order.
My response to this gripe is, So what?
Volatility (short-term or temporary losses) is not the same thing as risk (long-term or permanent losses). Risk is serious, potentially fatal. Volatility is merely a short-term sacrifice you make for long-term gain. In fact, volatility can be an ally and opportunity. Here’s how.
Let’s indulge in a thought experiment. Imagine you are standing at the edge of a wilderness forest and you spot a brush fire in the distance. If you were a firefighter, you would be tempted to run to it and put the fire out. And that is exactly what firefighters did for many years. However, much to their astonishment, they saw that the fires not only came back, they also came back as bigger fires that lasted longer. Gradually, firefighters realized that small fires flame themselves out naturally; more importantly, because they remove brush, they serve to keep small fires from ballooning into a catastrophic wildfire. So, firefighters finally took the contrarian approach of ignoring frequent but short-lived fires.
In the same vein, volatility is the frequent but short-lived price fluctuations that cleanse the market and prevent the sharp plunge that could wreak major havoc. Think of volatility as the small brushfire that flames itself out, while risk is a catastrophic wildfire that rages on. And that is why I want you to embrace the idea that instead of doing harm, volatility can do some good.
Volatility Can Be Your Friend Instead of Your Foe
Just as a brief illness builds your immune system, learn to think of volatility as a healthy interlude on the road to a stronger market eventually. If you have determined, with careful research, that the underlying business is resilient or building resilience, the setback in price will prove temporary. More than that, it now presents a terrific investment opportunity. Let me explain.
If the fundamentals of the business have not materially changed and its intrinsic value—what the business is worth—is not impaired, a sinking stock price is an opportunity to gain even higher returns at lower risk. This is how the opportunity to invest in American Express stock came about. In 2016, the company faced an unexpected loss of a large credit card contract with Costco. Fearing the large air pocket in earnings would bring price volatility, investors dumped the stock, and its price sank from the mid-80s to the mid-50s in a matter of months. My research told me that it was only a matter of time before the company replaced the lost revenue stream by signing up new clients. I had estimated the intrinsic value at about $100 under a base-case scenario, while my downside risk in a worst-case scenario was in the $50 range. When the stock fell to $55, the upside calculation rose to 82 percent [(100−55)/55], while the downside was a mere 9 percent [(55−50)/55].
Several things are worth pointing out here. Notice how the share-price volatility dramatically improves the upside/downside ratio, which is none other than the risk/reward ratio. The risk has been reduced because the share price has gone well below the base-case intrinsic value. (Remember, my assessment of this intrinsic value had not changed.) Note, too, that the greater the discount to intrinsic value, the larger the margin of safety and the greater the reward. As the price falls, there is a bigger reward and lower risk.
This is the crucial difference between volatility and risk: the former is temporal and short-lived, while the latter is structural and impairs the business permanently. Volatility is an opportunity because it only affects the stock price, while risk is a threat because it affects the intrinsic worth of the business.
“Investing is not a confidence game: it is about being more correct, not being more confident.”
I do realize that making this shift in thinking can be difficult. Watching prices crash is excruciatingly painful. All of us would like to avoid pain if at all possible. But if you make hasty decisions in the face of volatility solely to avoid short-term pain at all cost, you risk leaving too much money on the table.
I learned this the hard way when I swapped two stocks because of currency volatility. At 5:35 a.m. on January 15, 2015, I was rudely awoken from my deep sleep when my trader called to tell me that the Swiss National Bank (SNB) had scrapped the currency’s peg to the euro, causing the Swiss franc to shoot up by 30 percent intraday! As over 40 percent of Swiss exports go to the euro zone, firms across Switzerland warned of a hit to earnings. I feared that the SNB would continue to manipulate the currency, hurting the earnings of exporter stocks such as Nestle while helping domestic stocks such as Swisscom. So, I added to my Swisscom position and pared back my position in Nestle. That call proved shortsighted. Once the knee-jerk reaction subsided and the currency stabilized, the volatility evaporated, and over the next few years, Nestle stock performed much better than Swisscom. In hindsight, I should have looked past this noise and focused on the long-term earnings power and staying power of the respective businesses.
Volatility: Can Be an Opportunity Instead of a Threat
Volatility has another benefit for investors: it helps clarify the distinction between conviction and correctness and nudges them toward the latter. Conviction (aka confidence or hubris) will lead people to make a decision about a certain stock based on some sort of gut feeling—a whim, a hunch. But investing is not a confidence game; it is about being more correct, not being more confident.
“Volatility is an opportunity because it only affects the stock price, while risk is a threat because it impacts the intrinsic worth of the business.”
Smart investors know they need to research the fundamental intrinsic value of equities they are considering; that research is what gives them correctness. And that’s where volatility comes in. When a stock suddenly drops in price, everyone “feels” there is a big problem with the company. But if you have done your homework, in the form of painstaking research, and have verified that the underlying value is intact, suddenly the balance beam tips in your favor. Your research proves everyone else’s assessment is wrong. Now you are looking at a bargain.
In summary, then, an undue focus on avoiding volatility because of short-term pain often proves counterproductive to your long-term gain. Yes, equities come with some short-term volatility. This does not mean you should turn your back on their long-term superior returns. Your investment focus should be on reducing risk, not reducing volatility.
There is another reason to invest in equities. It is your invitation to an awesome party—a seat at the table to celebrate innovation, the struggle to overcome challenges, and the ingenuity to solve problems. Silicon Valley, to use just one example, is built on equities, not bonds. From Google, which put the world’s information at your fingertips, to Amazon, which brought a gigantic assortment of merchandise to your doorstep, business is predominantly funded by equity.
Risks of Equities: First in Line to Take the Bullets, Last in Line to Get the Goodies
Now let me walk you through the relevant risks in equities, because I do not want to sugarcoat what can go wrong. You may wish you did not know the downside, but ignorance or denial is not going to help you overcome your fear of risk—only knowledge and understanding will. So, let’s first acknowledge and understand the risks of equities, before we turn to non-consensus investing to help mitigate them.
Equity shareholders—people who own stock in a company—occupy a “worst of all worlds” when it comes to claiming a piece of the financial pie. Their piece must come out of what is known as free cash flow. Free cash flows represent the surplus cash flows a company generates after:
1. Paying all expenses of the business
2. Reinvesting in the business to support ongoing operations or growth
3. Setting aside money to pay back long-term liabilities
After all those business needs have been dealt with, whatever is left is available to distribute to shareholders in the form of cash dividends or share buybacks. Take note of what this means: equity shareholders are last in line to get cash out of the business—if any is left over.
Consider the Hershey Company, makers of chocolate. First, Hershey has to pay the vendors who supply the raw materials such as cocoa, sugar, oil, flour, milk, and eggs. Then it has to pay employees in the factory who make the chocolates. The company incurs depreciation on its manufacturing facilities to account for wear and tear. It has to pay for marketing and advertising programs that remind us how much we love candy and entice us toward new delicacies. It incurs transportation, sales, and distribution costs to ensure its chocolates get onto the retailers’ shelves, so we can buy it when we go grocery shopping. It has to pay taxes to the government, and incurs capital expenditures and other investments such as research and development to keep the business in good operating condition and to position it for growth. Finally, the company needs to set aside money to meet the working capital needs of the business and repay long-term liabilities such as pensions and debt.
Clearly, being last in line means there is a risk that equity shareholders may not get any or all of their investment back. And that’s not all. Equity shareholders are also first in line to be called to put up additional money needed by the business or the bankers. If the business experiences a setback and makes a loss, or bankers need the company to put up more equity capital to reduce financial leverage ratios, it is the shareholders who provide that additional capital.
This is why I earlier described owning equities as “the worst of all worlds.” Equity shareholders are first in line to absorb losses and last in line to be paid. Obviously, this is a very risky position to be in, so people who are willing to invest equity capital must be given a sufficiently significant incentive in the form of large upside potential to attract necessary investment dollars to fund the business. And therein lies the positive side of being an equity investor: you get a chance to make outsize returns if you choose well.
This is exactly what my investment approach strives to do. It tries to take advantage of both the volatility and the value-creation potential of equities and helps me choose well, to make higher returns without taking higher risk.
By the way, this explains why the United States is among the most successful and prosperous countries in the world: it is built on the shoulders of entrepreneurs and small-business owners who are none other than equity shareholders. The only difference is that they own private companies while our focus is on public equities, but the principle is the same. Equities enable you to become extraordinarily wealthy if you choose well. To realize how mammoth the rewards of equity investing have been for America, consider this: The United States dominates the global equity benchmarks when different countries are given a weight in proportion to the size of their respective equity markets. Measured this way, as of December, 2018, the United States has a weight of 54 percent, while forty-five other countries have a combined weight of 46 percent. America epitomizes the power and payoff of equities.
Investing in Bonds
No discussion of stocks is complete without discussing their opposite: bonds. Given that so much attention has been focused on the appeal of bonds—their stability and steady interest income—let me give you the other side of the coin: their risks.
Inflation Risk
Bonds may represent an optical illusion. I say illusion because many investors focus on nominal prices (which matter less) instead of real prices (which matter more). Here’s an easy way to understand this important distinction. Imagine you get a 5 percent raise, and your boss tells you that you should be happy because your wages have gone up 5 percent. However, if your cost of living—inflation—also goes up 5 percent, your real purchasing power is unchanged. For you to come out ahead, wage growth must exceed inflation. In the same way, if you want to maintain, let alone improve, your standard of living, your savings (aka nest egg) must outpace inflation.
If your nest egg is invested in bonds, and if inflation grows faster than what bonds are pricing in (meaning that inflation expectations are implicitly embedded in the price), you risk losing your real purchasing power and thus eroding your standard of living.
Therefore, you are taking a risk in owning bonds, except the risk has a different name: inflation risk instead of volatility risk. By owning bonds, you have not reduced risk, you have only swapped it. Risk by any other name is still risk.
The reason people fear equities is that their volatility is easily visible. Investors are seduced and soothed by bonds because inflation is less visible. This is what makes inflation risk (and therefore the risk of owning bonds) even more sinister—you do not see it coming. It is a bit like putting on weight: it is not noticeable on any given day because it happens very gradually, almost imperceptibly. You may think bonds are not risky because they have gone up in price in the past few decades while inflation has fallen (inflation and bond prices are inversely correlated; when one goes up, the other falls). However, if the opposite happens and inflation rises, bond prices will fall.
And that’s not all. In addition to inflation, other risks are embedded in bonds. One is credit risk. If the credit metrics (akin to credit scores) are low or deteriorate, then credit risk goes up, the bond becomes riskier, and a higher interest rate must be charged. Since the price of the bond is inversely correlated with interest rates, if rates go up, the price of the bond falls, and vice versa.
Credit Risk
Here’s an easy way to think about this. A credit card loan is unsecured and therefore has a greater credit risk than a mortgage loan, which is secured (collateralized by a house). In 2018, credit cards charged around 16 percent interest on unpaid balances (tantamount to a loan); secured mortgages came with an interest rate of about 5 percent. The difference in rates (also referred to as credit spreads) for the two types of loans reflects the difference in credit risks.
Of late, in 2017 and 2018, amid rising budget deficits, relatively robust economic growth, and inflationary pressures building in the U.S. economy, the Federal Reserve Bank had started to raise rates. This caused longer-dated bond prices to fall, creating losses for investors who owned the bonds before the rate increases. Government Treasury bonds or bills often pay the lowest interest rates because they are viewed as the lowest-risk investment; in fact, they are frequently referred to as risk-free return. However, this can be a red herring. If the creditworthiness of the U.S. government is called into question, the price of U.S. Treasuries can fall. Then the presumed risk-free return morphs into return-free risk.
Right about now, many would protest that the creditworthiness of the U.S. government is absolutely sound. Not necessarily. Note that one of the three main rating agencies, S&P, downgraded the United States from AAA to AA+ in August 2011, for the first time in more than seventy years. Recent corporate tax cuts and other forms of spending or stimulus have resulted in a $1 trillion budget deficit in 2018. These deficits continue to add to our debt obligations, which now amount to about $15 trillion. If we add the $45 trillion estimated present value of future liabilities such as Medicare, Medicaid, and Social Security, the total liabilities amount to $60 trillion. This is a ginormous debt burden to shoulder, let alone repay, and it exposes bond investors to heightened credit risk.
Default Risk
You need to be aware of debt risk and its implications: the greater the indebtedness, the worse the creditworthiness. Bonds are not risk-free in and of themselves. If someone—a consumer, company, or country—borrows too much, then bonds can become very risky. In the aftermath of the 2008 financial crisis, the U.S. Federal Reserve Bank tried to resuscitate the economy by engaging in quantitative easing, forcing interest rates lower than they would otherwise be. This led many to go on a borrowing binge. Then, as interest rates go up and risk appetite goes down, many borrowers may have difficulty repaying their debt. This is called default risk.
These examples describe some of the different types of risks bond investors are exposed to. When these risks unfold, the dream of stability associated with bonds may turn into a nightmare of volatility. This is what happened in the UK, whose bonds (called gilts) show eerie parallels with U.S. Treasuries.
Throughout the first half of the twentieth century, the United Kingdom was the world’s superpower, and the pound sterling was the reserve currency (meaning the one most people preferred to trade in, just as U.S. dollars are today). For sixty years, interest rates were range-bound between 2 and 5 percent; then, in just over twenty years, they shot up to 15 percent (see figure 3.2). The UK never regained its former glory. The trigger for this instability was the record fiscal deficits and liabilities that the government simply could not meet. The United States is fast confronting such a predicament with its pay-as-you-go policies on important social programs such as Social Security and Medicare. These liabilities are not funded and therefore do not show up in the official debt statistics, but they are real, and coming due.
FIGURE 3.2 UK government bond yields. Source: ONS Bank of England.
Liquidity Risk
Another risk that is ignored by many bond investors is liquidity risk. If you cannot sell something to generate cash, it is an illiquid asset, and it is worth far less than a liquid one. I learned about liquidity risk firsthand. My dad made an astute but illiquid investment in buying a seat on the Bombay Stock Exchange (India’s equivalent of the New York Stock Exchange). That single investment of a few thousand rupees appreciated to several million rupees several decades later, but in the meantime, it brought little solace to our family because we could not liquidate it to pay for day-to-day expenses.
Most bonds, especially corporate bonds, are far less liquid than equities. If you need to sell them, you may not find a buyer right away, and you may have to offer significant discounts to their fair value to entice bids. With quantitative tightening underway (the Federal Reserve is tightening the money supply in the economy), the illiquidity risk of bonds may become more severe as easy money disappears. Investors got a taste of how big and unexpected this risk can be in December 2015, as signs of stress grew in credit markets. The $788 million Third Avenue Focused Credit Fund blocked clients from redeeming their money, as the alternative was a fire sale with a significant markdown on their realizable value.
Of course, not all bonds are illiquid, but most are. On one hand, U.S. Treasuries are very liquid, but on the other hand, say, sovereign or corporate debt issued by countries or companies in emerging markets can be fraught with illiquidity risk.
Valuation Risk
Another associated risk in bonds is that, because of their less liquid nature, they are harder to value accurately. Few transactions occur, so prices cannot be validated but are assumed to be what is quoted by two dealers. However, these quotes represent an indicative price, not a guarantee. You will only know their true value when you sell them. This takes us right back to the illiquidity risk. If you cannot liquidate, you cannot establish real value. Illiquidity risk exacerbates valuation risk.
Most bond managers underplay this risk, claiming they will hold the bond to maturity. But what if you need the cash before then? Consider the plight of people who had invested in a bond fund managed by GAM. When irregularities in the risk-management and record-keeping procedures were found, the portfolio manager was suspended, and bondholders were prevented from redeeming their $7.3 billion investment.
In November 2016, ratings agency Fitch warned that a mismatch within open-ended bond funds offering daily liquidity while holding less liquid securities had increased to a record high. Fitch analyst Manuel Arrive cautioned, “Drawdowns resulting from fire sales in illiquid markets increasingly put fund capital at risk, as bond carry returns have become insufficient to offset volatility.”2
Capped Upside Risk
There’s one more type of risk, and it is a big one: Bonds can expose you to large losses but cannot offer large gains (unless you buy them in the secondary market at a huge discount to their face value). That is because a bond’s upside is capped at par.3 Let’s say you hold a bond with a par value of $100. At any point before its maturation date, that same bond can fall in price to $70 or $60 or even lower. If you have to cash out when the price is down, you lose. But even if you hold the bond to maturity, you cannot get repaid a cent over $100. This asymmetry means that if you do not buy bonds at a significant discount to their par value in the first place, there is no upside, but there is always a chance of downside. Buying bonds at par can represent return-free risk instead of risk-free return. Why would you bother?
Conclusion: Stocks or Bonds?
In the short term, you may not perceive bonds as risky because inflation has fallen, not risen, or because companies whose bonds you own have not defaulted. But there are significant risks embedded in bonds, even if they are not immediately apparent, and you ignore them at your peril. When these risks manifest themselves in the future, bonds may prove to be an inferior investment choice. Bottom line: It is naive to think that bonds do not come with any risk. They just come with a different risk.
On the other hand, choosing equities is a bit like parenting—there are more ups and downs (volatility), but they are also worth it in the fullness of time (value creation). Think of owning stocks of quality businesses akin to raising a child whose best days are still ahead of her. Sure, she may act up now and then, but you do not give up on a child just because of a few stumbles. Children, like stocks, may not offer joy every day, and on some days, they may bring pure nuisance and annoyance, but you would not decide not to have kids because some bad comes with the overwhelming good. Just as helping your children grow can be among the best rewards of life, investing in stocks can be among the best investment decisions you can make for your family and those who entrust their investment decisions to you.
I am not saying bonds do not have a role in your investment portfolio, or that stocks should occupy prime position for everyone or at all times. Each investor should consider the suitability of allocating to stocks versus bonds based on their own circumstances. I wrote this chapter to call your attention to the risks of bonds and the rewards of stocks because popular perception is the opposite. A contrarian investor should always consider alternative perspectives, especially when they are being overlooked by others.
Top Takeaways
1. Investing is about winning by choice, not chance.
2. Volatility is not risk.
3. Bonds are neither risk free nor low risk. They come with different risk, not no risk. Bonds expose you to inflation, credit, default, illiquidity, and valuation risks. Stocks may depress your mood occasionally, but bonds may depress the returns of your nest egg permanently.
4. In theory, equity investors assume more risk; in practice, by owning high-quality businesses and not overpaying for them, you can dramatically lower that risk.
5. Non-consensus investing strives to take advantage of both—the volatility and value creation attributes of equities, to improve the odds of generating superior risk-adjusted returns.
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1. In a literal sense, the term “volatility” means large oscillations in stock prices. It could describe a sudden upswing as well as a heart-stopping drop. But since it is the occurrence of precipitous drops that causes distress, that will be our focus here.
3. No, not golf. A bond entails repayment of a fixed principal amount called its par value. The maximum amount you are repaid when the bond becomes due at maturity is this fixed, capped amount.