BY: JOHN MCCOLLUM
Chief Investment Officer
The idea of expected return is critical to making investment decisions. Expected return is simply the annualized growth and income an investor expects to receive on a particular investment, over the time the investment is held. The term is often applied generically to classes of investments like stocks or bonds.
All other things being equal, the higher the expected return, the more attractive the investment. That’s pretty simple, but as we all know, all other things are not equal. The first “other thing” that investors must be concerned with is risk. Academics and many finance practitioners define risk as the volatility of returns. Volatility (the actual academic term is standard deviation) is, simply put, the expected range of possibilities for the value of an investment over a certain period of time.
A simple investment, such as a $1,000 bank deposit guaranteed to pay 2% for a year plus the return of the $1,000 at the end of the year, has almost no risk. And so, we are able to calculate with great precision the value of such an investment at the end of each year. A bank account is a very safe investment and has nearly zero volatility.
At the other extreme of risk might be an investment in the stock of an early-stage technology company. Very generally, the stock price (I have intentionally not used the word value) of a technology company represents the market’s expectation for earnings (and dividends, if any) and how fast these might grow many years into the future.
These expectations for growth and earnings can change rapidly and sharply due to changes in sales, new products, competing products, new regulations, and a host of other factors. As investors digest ever-more information, the stock prices of these companies can change rapidly. Both up and down. This volatility, which comes from an uncertain future, is one important form of risk.
The real risk for most of us in making investments, however, is the risk of losing money. And to be more specific, it’s the risk of losing purchasing power. Not only do we need a return of our investment, we need a return on our investment in order to keep up with inflation and the rising prices of clothing, housing, and other necessities (including comfort). And the kinds of investments likely to keep up with inflation are usually not the investments that have near perfect certainty about their future values (like the bank account).
We certainly want to avoid investments where the probability of losing money is too high. But sometimes, in the right proportions, a collection of riskier investments, including some that unfortunately turn out to be losers, makes sense. Howard Schultz, the founder and former CEO of Starbucks, once said that in 2008 he believed his company was seven months away from insolvency. There was a real risk that an investment in Starbucks at that time would end up as a total loss. Instead, 11 years later, the company is now worth $50 billion.
Many investors have come to believe that common stocks offer very good expected returns. They do – but they come with volatility. Stock prices don’t go up in nice straight lines and often they go down. To earn the high returns that common stocks can offer, one must be prepared to give them time – certainly more than five years – and be prepared for the times in between when owning stocks doesn’t feel very good.