Recall from last Friday’s post the sentence buried in the excerpted block quotation from Ernest Dimnet’s The Art of Thinking: “Even the sacrosanct thing called plain common sense is not enough to intimidate [the thinker] into conformity.”
A most commonsensical notion in the field of investment is that risk and return are positively correlated; i.e., if you expect to earn higher-than-average returns you must be willing to accept greater-than-average risk. Can you think of a single game of chance in which this does not apply? Consider the odds of drawing to an inside straight in poker. Of the 52 cards in the deck, given that none of the 5 in your hand is the desired card, 47 remain unseen. If the card sought is, say, a 7, of any of the four suits, your odds of success are 4/47. In terms of probabilities, if you find yourself in this predicament you will be successful only 8.51% of the time. Of course, dropping one card for the inside straight draw also gives you a shot at drawing a pair, but there I am getting in over my head and off-topic.
The point of this illustration is made with everyday statistics: If you do draw for the inside straight, you will complete a straight in only 8 out of every 100 hands (outcomes are binary and my conservative nature would always have me rounding down!). Given that 91.49% of the times you draw for it you will lose your bet, for every $1.00 wagered, your roughly one-in-10 payoff must be a whopping $10.75 just to break even! Ergo, the commonsensical notion that high returns require taking high risks.
If you think that investing is analogous to a coin toss, then no doubt the positive correlation stands. But in the quotation Dimnet also warns about “repeating formulas.” What if the outcomes from investment are not entirely random, as formulaic thinking purports? What if Warren Buffett, as exemplar, is not simply a statistical anomaly?
For argument’s sake, let’s assume we concede at least some credence to the concepts of intrinsic value and mean reversion. To be sure, using the image of a swinging pendulum flirts with grossly understating the uncertainties associated with such assumptions, but I would argue that the laws of physics should also not be rejected out of hand when applied to the non-physical sciences.
About the following, there should be no doubt. If an asset’s intrinsic worth is estimated to be X, it is economically more advantageous–I might even say less risky—to to purchase it at .5 times intrinsic value than 1.5 times intrinsic value. That assumes, of course, that price and value tend to converge, that they have a central tendency. Moreover, since intrinsic value tends to be more stable than the whimsical nature of investors both individually and in the aggregate, it’s the market price of the asset that will be doing most of the converging.
Let’s throw another variable into the mix. Theoretically, for individual investors, the game doesn’t require an ante, and unlike baseball, there are no called strikes. While it takes a strong temperament and a keen nose for value, one need only swing at an asset selling for .5 times intrinsic value. Tempted as one might be, it’s in their best interest to let pitches outside their sweet spot pass. Thinking is action in repose. Based on an advisor’s absence from tout television’s interview circuit and the dearth of calls he receives from sell side analysts, a manager might appear asleep at the plate. He’s anything but dozing. By his inaction, he simply looks that way! Lest my thinking without necessarily acting be misinterpreted, Mark Twain’s famous quotation on rumors of his demise—“The reports of my death are greatly exaggerated”—is always on my lip.
Here’s where things get interesting. Above I posited that purchasing an asset for a price less than its intrinsic worth, X, is less risky than paying a premium to X. What about return? Logically, if you buy that asset at a discount to its intrinsic value which presumably grows at some positive rate, your total return will be the combination of the convergence of price toward value plus the growth in intrinsic value. What I’m proposing is this: If it’s high returns that you desire, only low risk investments are the means to reach that end. In games of chance the high risk/high return paradigm applies. If the casino capitalism model is the way an investor approaches portfolio management, that paradigm also fits well. But for the rational, thinking, patient, and fiercely independent value investor, he can stack the odds in his favor and create his own low risk/high return paradigm. I believe the correct answer to the title question is “no,” and, further, under circumstances such as those outlined above, risk and return can actually be negatively correlated. Now that’s something to think about.