Who Wants a 20% Annual Risk-Free Return?

Here are the best things I read and thought about today –

• Matt Levine writes on Bloomberg that gambling is not a retirement plan. He writes about a few people – common people like you and me, including a few 60-80 year old – who bought leveraged exchange-traded notes (ETN – complex financial instruments that use debt to amplify returns, which also increases risk) that promised unreasonably high returns, and lost their money in the volatility of the last few months. He then quips (emphasis mine) –
  

  I have long argued that the most important lesson of “financial literacy,” one that is never taught in any “financial literacy” classes, is: If I offer you a 20% annual risk-free return, am I lying? The answer is yes, of course.

  UBS was not actually offering a 20% annual risk-free return — the ETN “often yielded 20% or more” but didn’t advertise any fixed interest rate, and it said right on the front page that it was risky — but just knowing that single core fact of financial literacy would be sufficient to guide your investment decision here.

  “Ooh fun gamble, 20% return, maybe I’ll take a chance on it”: Fine, great, whatever. “Hmm this seems to offer monthly income, and a 20% return would help my retirement, guess I should put all my savings into it”: No, bad, wrong.

  Consider the stock market.

  The original design of the stock market was purely capitalist in intention. It was created to provide a means for business people – entrepreneurs, inventors, developers – to obtain needed investment capital, to start or to expand their businesses. So stocks were issued, bankers and other investors bought the stock, and the businesses made use of the invested money. But once a business started flourishing and was producing a profit, it returned the money back to the stock holders so that it could be used by other enterprises.

  Over the years, however, this last part of the process was completely forgotten. As years passed, the brokers quickly realized that they could make lots of easy money in trading shares back and forth. They became middlemen, in charge of the flow of capital, earning their commission on each and every transaction.

  As we see now, the game is no longer just about capital and businesses, and has become one where everything is centered on the flow of money from one investor to another, instead of one business to another. And in this flow, investors get doomed time and again because they fall for the “20% annual risk-free return” kind of promises! And brokers and other middlemen earn their commissions even on such doom.

  This is exactly like it happens in a casino. One gambler gets rich at the expense of others, but ultimately loses it all. But whatever happens, the broker (the casino) always wins.

  Asking the question Levine poses – If I offer you a 20% annual risk-free return, am I lying? – the answer for which is – Yes, of course, I am lying – will save you from a lot of blushes and disasters not just in the stock market but also in your broader financial life.
   

• Massive up and down moves in stocks in the same year are more common than you think, argues Ben Carlson in his latest post –
  

  You can get cycles during a 12-month time frame that feel like they should be playing out over the course of 12 years.

  The stock market can move very fast in either direction seemingly without warning.

  Here are some reminders I like to consider when thinking through big moves like this:

  • I cannot predict the direction of the stock market over the short-term.
  • I cannot predict the magnitude of stock market moves.
  • I cannot predict when market moves are going to start or stop.
  • The stock market doesn’t always make sense nor does it have to.
  • The stock market has the ability to make everyone look foolish at times.

   
  Things looked bleak in March. Now things look not so bad considering the S&P 500 is down just 2-3% on the year. What happens next is anyone’s guess.

  I don’t know.

  Well, nobody knows. Worse, we all are ignorant of our own ignorance.
   

• Aswath Damodaran, sometimes known as the ‘Dean of Valuation,’ recently spoke at the 73rd CFA Institute Annual Virtual Conference on the topic The Value of Everything in an Unstable Environment) –
  

  Considering valuation principles in light of the COVID-19 crisis:
   

  • Valuation first principles have not changed just because of the crisis, but investors have to be willing not only to make estimates about the damage that the crisis will cause to corporate earnings but also to think about what a company will look like in the post-coronavirus economy.
  • If you are tempted to use multiples and pricing because you don’t want to make assumptions in the fact of uncertainty, you will find uncertainty affecting you in different ways, with trailing numbers moving dramatically and multiples becoming either not meaningful or not usable.
  • Difficult times require dynamic models, where forecasts of the past are not anchored in past numbers. In other words, mechanical models (which is what many DCF models have become in practice) will yield strange-looking numbers.
  • Ultimately, crises are crucibles that test investor faith and philosophies, and this crisis will be the acid test for active investing, in general, and value investing, in particular.

  Download Mr. Damodaran’s presentation here.
   

• Barry Ritholtz writes that if investors are worried about too much uncertainty, they should know that the world has always been like this –
  

  These may be unprecedented times, but they are not really out of the ordinary. Uncertainty always rules, and no one ever knows the future. For that reasons, no one really knows or even has a good sense of when the economy will recover, how many will die and when the pandemic will be over. Pretending otherwise with euphemisms does not make it any less so.

  Just remember that there is exactly the same amount of uncertainty now about the future as there always is. During times of crisis, you simply lose the ability to fool yourself about it.

• Ever wondered why very beautiful scenes can make you so melancholy or sad? The Book of Life has a beautiful answer –
  

  Beauty has served to highlight, by contrast, everything that has come before. We notice – in a way we couldn’t yesterday – how much disappointment, violence, meanness and humiliation has been written into the structure of our ordinary surroundings and routines and has from there seeped into our souls. Thanks to the little limestone church (that we’ll visit after breakfast) assembled by craftsmen around 1430 and ringing its bells for morning service, we’re finally in a position to feel how much agony is latent in our hearts. We haven’t been pain-free all this time, we’ve just been numb, holding in our sorrow because there was nowhere to discharge it, because there were no alternatives to it and nothing to remind us of the scale of our compromise.

  The beauty of the landscape is like the very kind friend who, after a period of turmoil, puts a hand gently on ours and asks how we have been – and does so with such tenderness and intelligent concern, we surprise ourselves by bursting into tears that don’t stop for a very long time. It takes kindness until we can realise how much suffering we were holding in. It takes beauty until we realise how far we have drifted from our better selves.

  Someone comes in and sees our eyes filled with tears. They wonder sweetly if they could fetch us anything to eat – or a taxi to go sightseeing. But we are far stranger than we can begin to explain. We are crying tears of joy at a goodness we have missed out on; we are crying because we don’t know how to nourish ourselves, we are crying at the sight of a happiness we are emotionally too cowardly, defensive and inept to know how to make our own. We are crying because we don’t want to be tourists, we want to be reborn.

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Have a great day. Stay safe.

With respect,
— Vishal