Sent December 2022
When you read the subject line above, it would be common to think about Rest and Relaxation (the not always-efficient military summed those weekend breaks for servicemen / women “R & R”), but I want to talk about a different R & R in this monthly correspondence, perhaps the most important financial concept that I could ever teach you: Risk and Return.
The Core of Investing
Investing at its very core is about taking risks for some future expected return. Most people don’t think about investing in that way, but it is intellectually imperative that we do so. The world of money – the world of finance – always and everywhere conceptualizes investing in this R & R fashion. Regular people – people like you and me – generally just think about the “return” piece. However, please make no mistake that the “risk” piece is inextricably always and everywhere attached to the “return” piece. Spoiler alert: Let me share the reality that you actually want risk in your investment life. Let me give you some examples that will exemplify this concept.
The Basics of Risk and Return
If you put money into a bank savings account, you expect some interest to be paid. For the past 10-years or so that interest was squat, but it’s now 0.5% – 2.5%. What’s the risk to you? Nothing actually, as your money is FDIC insured (at least if you put in $250,000 or less). You put in a buck, and you get back a buck squat.
Okay, now let’s take a trip to the other end of the spectrum and say you buy a buck of stock. Do you have an “expectation” that you will get something for that dollar invested? Sure you do, and whether you know it or not, that expected returns is about 7%-12% per year, averaging 10%[i].
Why Risk Is Key
Now let’s stop right here for a brief respite on our journey. If everyone could get a 10% return versus 2.5%, no one would want to put money into a bank. Thus we see that the difference isn’t the average expectation of return, the difference is the risk. Risk is the sole determining factor of that return.
The Risks of a Stock
What are the risks of a stock?
Franky, there are many, but here are the top three:
1. Concentration Risk
The stock could go up in value, maybe tremendously up, but it doesn’t have to go higher in price. Frankly, the share price could go to zero, which would happen if the company went bankrupt. That’s concentration risk.
2. Control Risk
It is true that you have purchased an ownership share in the company and have a legal right to all the future earnings of the company, but you have no control over company operations. You can vote your one share at the annual shareholders meeting, but I think it is fair to say that it will not have much impact. That’s control risk.
3. Stability Risk
Finally, at least for now, as you are painfully aware from fluctuations in 2022, equity markets go up and down about 19.7% per year[ii]. However, it might be instructive as well as helpful for you to know that individual stocks go up and down about 250% (2.56x) more than the market as a whole[iii]. The term for this volatility is commonly expressed as Standard Deviation. Thus, if you need your $1.00 cashed out right now for some emergency or opportunity need you are facing and the stock is down 50%, you will only get $0.50. That’s not liquidity risk as you can generally get out of a stock, but it is stability risk, because you don’t know what price at the precise point in time when you need to get out.
What This Means For You
Smart person that you are, you say, “This is freaking nuts!” You just want the 10% per year average return, or you want the home run company that goes up 500%. Well, hallelujah, so does everyone else fishing in the equity boat. We are wanting to pull in that big one, but we have to take the risk of getting skunked.
Bonds
For the record, bonds (Fixed Income) are in the middle of the two above categorized. You might get 3% -5% annual return on good high-quality bonds. What’s the difference? Risk. There’s that word again. Bonds do carry a higher interest rate than savings accounts, but they have two risks called “Term” and “Credit.” Average bonds are down 14% – 18%[iv] this current calendar year – which is a highly exceptional year due to Federal Central Bank interest rate increases – but again it’s risk that is everywhere and always present.
Avoiding Concentration Risk
All this possibly sounds like a bad Grinch story to you but let me change that perspective. The domestic stocks in Wellspring clients’ portfolios are down a quarter less than what the market averages this year and have given our clients 12.3% per annum over the past 10 years[v]. Our clients are able to get that attractive average return because of risk… not in spite of risk. Wellspring mitigates our clients’ risk in numerous ways but avoiding concentration risk is one of those ways — which is why our clients own over 14,000 stocks[vi]. Risk is your friend. Now, to be fair, if we tried to concentrate risk, then our clients’ return should be a lot higher – but to take that chance we would run a large uncompensated risk of the return being a lot lower.
Here are two recent concentrated risks that our clients have avoided:
- FTX… The darling crypto currency exchange run by Sam Bankman-Fried that has recently declared bankruptcy.
- Twitter… The social media platform recently acquired by Elon Musk, which I think it is fair to say has a few challenges at present. Wellspring clients previously owned a small piece of it (0.026%[vii]) but that got cashed out when Mr. Musk acquired the company.
R = R
Thus, as we have seen by these examples, the world “prices in risk” into the value of every investment security. This concept of R = R keeps everyone honest and is one of the lynchpins of intelligent investing and the foundation of capital markets. If there is one key aspect of Wellspring’s investments, it is that we are taking the best risk /return trade-offs we can find. We treat our clients like family… because they are family to us.
It remains my deep and distinct honor to serve you.
Patrick Zumbusch
Founder and CEO
Wellspring Financial Partners
[i] “Average Historical Stock Market Returns For S&P 500 (5-year up to 150-year averages)” (TradeThatSwing.com, November 29, 2022)
[ii] “Annual Returns Of The S&P500 From 1928 to 2015” (Seeking Alpha, February 24, 2016)
[iii] “Have Individual Stocks Become More Volatile; An Empirical Exploration Of Idiosyncratic Risk” (John Campbell / M. Lettau / B. Malkiel / Y Xu, National Bureau Of Economic Research, March, 2000)
[iv] Barclays Aggregate Bond Return Year-to-Date Through September 30, 2022 (Retirement Plan Advisory Group, 3rd Quarter Scorecard)
[v] Fund Center: Investments 10-year Returns Ending October 31, 2022 (Dimensional Core Equity II Portfolio, Dimensional Fund Advisors, November 29, 2022)
[vi] Fund Holdings Aggregate; Domestic Core II, International Core, Emerging Markets Core, Domestic Real Estate Securities Portfolio (Fund Fact Sheet(s): Holdings, Dimensional Fund Advisors, November 29, 2022)
[vii] Domestic Core II Mutual Fund Holding of Twitter At September 30, 2022 (Private Correspondence With Dimensional Fund Advisors, November 28, 2022)
