Understand Asset Pricing to Get Paid. Not Played.

To win at investing, you must buy something lower and sell it higher. So, price matters. You also don’t want to lose the invested money. The relationship between potential risk and reward for the investment underpins asset pricing. What you pay or get paid when you buy or sell. A deep understanding of how that works is vital to succeed at investing. Learn about how asset pricing in efficient markets works.

That sounds complicated and scary, but it isn’t. On the contrary, confidence and competence in this will help shield you from bad advice and instincts. When you risk your capital to invest, you want to get paid. Not played.

You will commonly hear that risk and return are related. If an expected investment return seems too good to be true, then you are likely missing some important risk. You don’t want to underestimate what that risk looks like to only realize it as it manifests for real. Conversely, if you want to earn higher returns, then you will need to take more risk. The key is to take risks that are likely to be compensated and avoid or mitigate uncompensated risks as much as possible.

The chart below illustrates how this risk-reward relationship has played out over the long-term history of public market data. That is a 90-year track record that spans recessions, wars, financial crises, political shenanigans, disruptive technologies, and countless seasons of The Young and the Restless.

risk return investing

The signal is pretty clear. The lowest-risk investments, like US short-term treasuries, barely outpaced inflation. Longer-term debt has more risk exposure and a slightly higher return. Equities have had a much higher return relative to inflation, and the smaller riskier stocks outperformed inflation by the widest margin. There are plenty of price swings along the way. That volatility looks minor now, but did not feel that way at the time.

Historical returns don’t predict the future. However, there are some important reasons why assets are priced the way that they are. Those “priced risks” are what we are seeing play out in the above chart relating risk and return for broad markets. But first, you have to understand what it is that you are buying.

Buying Cash Flow

When buying stocks or bonds, what you are actually buying is a claim on future expected cash flows. With a bond, that comes in the form of interest coupon payments. With a stock, you are buying equity in a company and a claim on that share of the company’s future profits. Sure, the company may have some physical assets of value. That is readily priced into its current value. What isn’t known is how the future cash flows will meet the current expectations.

asset pricing

Because the future is unknown, no rational investor would be willing to pay for future cash flow on a dollar-for-dollar basis. You would not give me $100 today just on the promise that I’ll pay you $100 from my cash flow five years from now. You would demand a discount in the current price relative to that future payback as compensation.

The further into the future and the less certain those cash flows are, the bigger a discount in the current price they warrant. With asset pricing, that discounting translates into a higher interest rate for bonds or a lower current share price for stocks.

Future Cash Flow Risk & Bond Pricing

With bonds, you are paying a discount on future cash flow by purchasing it at its face value. When the bond has reached maturity, it will have been worth its face value plus all of the interest payments along the way. That is pretty predictable compared to a company’s future profits. So, bond prices are usually much less volatile than stock prices. However, those coupon payments are not without risk.

If the debtor were to default then those future cash flows disappear. Hence, higher-risk debt commands a higher interest rate to entice investors to loan their money. Also, if you are locked into a bond for a longer period of time, there is a risk that interest rates or inflation may rise during that intervening period. That would mean lost opportunity compared to having the money available to buy a shiny new bond paying a higher rate instead. Or lost buying power relative to inflation. So, longer-duration bonds also demand a greater discount on the current price. We see that reflected as a higher interest rate.

Stock Price & Future Prospects

When you purchase a share of a company’s future cash flow by buying its stock, you rationally demand a discount related to the uncertainty of that predicted profit coming to fruition. The further into the future or more uncertain those potential profits are, the more you would discount as you move them back through time to the present.

As the future unfolds, changes in the economic environment, execution, competition, supply, demand, or Tweets from executives may alter the certainty of those future cash flows. So, the stock’s current price changes with that as a higher or lower discount is applied.

Similar to bonds, prevailing interest rates can also impact the pricing of stocks, based on expected future cash flows. An investor with a dollar to invest has to choose between the uncertainty of a stock vs the more certain but lower expected return of a bond. The higher the bond interest rate is, the more attractive an alternative it is. On a larger scale, competition for cash flows means discounting pressure on stock prices when interest rates are higher.

Volatility Reflects Future Cash Flows & Discount Rate Adjustments

This re-pricing of assets as new information becomes known happens constantly and continuously during the trading day. The more at risk those future cash flows are, the more the price fluctuates now with slight changes. It is like nudging an arrow on its flight path. A small adjustment now makes for a bigger miss the further away or smaller the target is.

capital asset pricing

We see this manifest as price volatility. Volatility can present its own risks. Like behavioral risk and sequence of return risk. However, it is often equated with risk for this reason of price moving more when the future returns are shrouded in greater uncertainty. Future expected cash flow may drop, decreasing price. If the certainty of even that cash flow is lower, it drops even more.

We saw that in March of 2020, many companies saw cash flows decrease and the degree of uncertainty was also very high due to the COVID-19 shock. That volatility also works in both directions as we saw with the subsequent whipsaw recovery. With plenty of money injected into the financial system by central banks, major stimulus spending by governments, and discounts further defanged by insanely low interest rates.

There are ways to attempt an estimate of future expected returns for an asset based on its current price and its historical performance. That has problems in that the future is not predictable by the past. However, from a broader market perspective, there are swings and a tendency to revert towards the mean. This is not tradeable information because the timing is not precise enough and the uncertainty is high. However, it is useful to illustrate one of the ways that we humans mess up our investing.

Recency Bias

Humans tend to overweight recent trends or price movements relative to the long-term trend. We also extrapolate that into the future. Future expected return estimates are tied to the longer-term past. So, when a market has recently made a big move in one direction, the future expected returns go the other way. For example, when the market has a major drawdown, that is actually when the future expected return is the highest.

However, due to our recency bias, we tend to extrapolate the recent downtrend into the future. It can cause us to sell when the future expected return is actually the best. There is data to document this phenomenon and it is stronger in markets where participants are more over-confident and attribute outcomes to themselves rather than the market environment. Kind of like the doctor’s lounge.

Investors’ expectations of future market returns are also lowest when future expected returns are the best. There is collated survey data showing not only that “feeling”, but that it causes money outflows at the worst possible time (action). Rational investors are on the other side of that trade. The winning side.

Don’t Get Played by Recency Bias.

Recognizing this recency bias, our feelings, and the counter-intuitive relationship to expected returns can help us to not get played. Played by the media, that presents extreme outcomes to attract eyeballs. Coupled with explanatory narratives about the current situation and why it will get more extreme. People are attracted to that and they get paid for views. Authors sell books about it. The narratives are also parroted by the arm-chair experts on social media, in the doctor’s lounge, and at family BBQs. Present company excluded.

Some of the social noise is just humans commiserating. Human nature. Remember those feelings and when you feel that way, it is also likely the opposite of what the future expected returns are. Invest accordingly. Avoid getting burned by chasing the recent hot trend. Don’t bail when everyone is talking about the impending recession or market crash. If the wailing reaches a crescendo, I just check the crack of the couch for any forgotten money to invest instead. Don’t get played by yourself!

recency bias investing

As the old saying goes, “When it rains, it pours”. Similarly, there is a propensity for some risks to manifest at the same time as others. With investing, that is called co-variance. For example, if I own stock in the same company that I work at. There is a significant chance that if there is some major disruption to the company’s prospects, both my cash flow from work and my stocks may drop in price at the same time. That is much riskier from a personal standpoint than just the characteristics of each on their own. How can that factor into asset pricing?

While investors price assets based on discounted future expected cash flow, they do that in the context of the rest of their lives. So, if the majority of investors have their human capital (job) tied to the economic cycle, then there could be a further discount for pricing assets that are also the most vulnerable to downturns at the same time.

Buying something subject to a bigger discount due to a factor beyond its future cash flow means getting a premium on the return moving forward. If those expected cash flows pan out. In other words, you could get a higher return for taking a risk that others are less willing to take but that you can handle.

Factor Premiums

For example, value stocks have historically returned a premium beyond just the broader market exposure. They may have increased risk causing their price to be lower than their current earnings. That could be rational because their risk of bankruptcy is higher. You’d expect that risk to future cash flow to be priced in. However, they also tend to get hit harder in market downturns.

The money-weighted aggregate of all investors may also face more risk to their non-investment cash flow at the same time. Banks, investment brokerages, and people with jobs tied to cyclical industries often suffer at the same time. Rationally, they may be only willing to pay a lower price to account for their co-variant risk. This may also be accentuated by behavioral bias and market inefficiencies. Fear can accentuate our perception of risk.

An investor who can weather those cyclical downturns may be able to realize a higher long-term return by taking advantage of that discount to price. Several other factors have historically returned premiums beyond what would be expected from simple market exposure. There are actually thousands of identified factors. However, only a handful have been persistent over time and pervasive across different markets.

You Could Get Paid or Played.

The market is the weighted aggregate pricing machine for the average investor. I’ll unpack that more in a post about efficient markets, but the “average” investor should likely invest in the whole market. However, if you have personal characteristics, such as human capital insulated from the economic cycle, you might be able to get paid for taking on extra compensated risk. Such as a “value-tilt”. You could even accentuate that with a small-cap value tilt.

However, it is also important to not get played. Don’t fool yourself. If you do have a lot of co-variance vulnerability or less risk tolerance than you think, you’ll likely find out at the worst possible time. When it rains. Even if you are in a strong position, your faith will be tested. Factor-tilted assets are harder to hold onto.

Even though they have a higher expected return in the long run, they can also trail the broader market for very long periods of time. Just look at the relative underperformance of the small-cap value vs small-cap growth ETFs below.

factor investing

To get paid, you had to watch value underperform for 14 years and hold it. Including while it got pummeled in the 2007/8 financial crisis, 2010/11 slow-down, and culminating in getting the Covid-laden snot kicked out of it in early 2020. It still hasn’t made up for the lost ground since 2007. Not even close. You need to be committed and confident in your factor-based strategy for multiple decades.

The impact of co-variance and factors may impact how investors may price assets in the context of their financial lives. In general, the main objective of investing is to make the most money possible. However, some investors may have other objectives. For example, gamified speculators are looking for excitement. That may override rational pricing. It statistically loses money overall, but still fills a need for them. Others may choose to invest in Environmental Social Governance (ESG) stocks or funds. In addition to investing for profit, they are also acting to have an impact aligned with their non-financial needs. Like their values.

That could translate into people being willing to pay more for ESG investments. Whether that translates into the impact they intend is debatable. However, from a pricing standpoint. If the markets are efficient, then the appeal of ESG and its likely future trajectory is already priced in. Don’t expect to get paid more. In terms of money, anyway. The only way to beat the market would be to know something about the future of ESG investing better than the aggregate market intelligence. More on that next week.

To Get Paid

  • Take compensated risks by investing in a diversified portfolio of assets that have future expected cash flow. That cash flow has some risk to justify the expected return.
  • Understand that prices will fluctuate along the way. Volatility is normal. It is expected.
  • Consider taking extra risks from factor-tilted investing only if it suits your financial situation (low co-variance), time frame (decades), and intestinal fortitude.
  • Invest money regularly when you have it and don’t need to save it for the near term.

To Get Played

  • Believe someone selling you an amazing investment opportunity with great returns and minimal risk. The risks are priced in. Even if you don’t recognize them.
  • Chase the recent hot trends.
  • Flee the markets due to the recent downturn.
  • Try to time the market based on expert predictions and narratives. They get paid to sell you the story. If you are reading, seeing, or even thinking about it – it is likely priced in.
  • Deny that you are likely paying a premium for investments that fill some other non-financial need for you.

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