The Nature of the Risk-Return Tradeoff

The reason why there’s a two-way tradeoff between return and risk; why you cannot and should not expect to find modest-risk investments with potential for large positive returns. That’s because the factors determine the magnitude (size) of potential outcomes are the same whether the outcomes turn out favorable or unfavorable.

• That which make it possible for an investment to return 50% in a good year is the same as that which makes it possible for a stock to lose 50% in a bad year.

• That which makes it likely that an investment will lose no more than 3% in a terrible year is exactly the same as that which makes if likely an investment can gain no more than 3% in a great year.

• Statistics that suggest otherwise do not mean what many would like to believe they mean.

For example, you may encounter a stock that has shown, over a long period of time, years in which maximum gains approximated 50% while maximum losses approximated 3%.

• This tells us the company and its stocks are inherently volatile; we know that because the data shows a history of 50% annual gains.

• This also tells us that the observation period consisted primarily, or perhaps entirely, of good years; we know this because we did not see any losses approaching 50%.

• But none of this allows us to assume that next year will again be good.

• If it turns out that next year is bade, the characteristics that allowed the stock to rack up 50% gains will likely operate to produce a 50% loss.

Here’s an example involving two hypothetical companies, A and B, and the respective stocks. In this example, we’ll see that different degrees of volatility are not matters of statistical study but are, in fact, inevitable based upon a substantial difference in an important fundamental characteristic, the extent to which a company’s cost structure is “fixed” (i.e. it does not move up and down in line with fluctuations in revenue), as opposed to variable.

For demonstration purposes, we’ll assume A and B are identical in all respects except the portion of costs that are fixed. Accordingly, we’ll make the following assumptions:

• Both companies have $1,000 of revenue in Year 1.

• Both experience revenue declines to $900 in year 2.

• Both companies are debt free.

• Both companies pay zero taxes (assumed for simplification purposes only).

• “Variable” expenses for each company go up or down year after year by the exact percentage change experienced in revenue.

• Both companies have 100 shares outstanding.

• Both earn net profits of $200 (and $2.00 per share) in Year 1.

• Each stock is priced at 20 times company earnings per share (EPS).

• Both stocks are priced at $40 at the end of Year 1 (EPS of $2.00 multiplied by 20).

The only difference is that Company A is more capital intense. Of the $800 in expenses each incurs in Year 1, $600 of Company A’s expense is fixed (it cannot vary up and down based on changes in revenue) while only $100 of expenses for Company B are fixed.

Table 1 shows what happens to each stock from the end of Year 1 through the end of Year 2 based solely on this difference in fixed-cost allocation:

Table 1

We see that the high proportion of fixed costs for Company A makes its profit stream much more sensitive to variations in revenue than is the case for Company B. Because the stock prices are tied to profits and EPS, the share returns are also subject to larger downturn.

It’s essential to recognize that A did not do anything wrong and its stock might actually turn out to be a fine investment. A simply has a riskier business structure, one that is more tied to fixed costs. Consider, for example, the difference between a heavy-equipment manufacturer like Caterpillar, which has a much heavier fixed-cost burden than, say, Starbucks, which does not operate large factories.

Also, don’t assume fixed costs are necessarily bad. Table 2 below shows what would have happened had revenues gone up 10% in Year 2.

Table 2

We see here that the same quality (fixed cost allocation) that makes A riskier on the downside also makes it more capable of producing better returns during good times.

There are many different ways such a dynamic plays out in the real world:

• Some businesses have inherently more volatile revenue streams. Consider, for example, the difference between a toothpaste maker (whose revenues may dip a bit during bad times as shoppers look for discounts, but not too much since toothpaste is a small portion of household expenses and since hygiene is widely regard as important at all times), versus a homebuilder, whose revenues tend to soar or plummet as people become willing and able to take on the large expenditures for new houses based on a variety of economic factors.

• Use of debt can make have similar impacts (interest costs are fixed). Hence Toothpaste-company C, which is debt free, is considerably less risky than Toothpaste-maker D, for which debt comprises 80% of its capitalization.

• Company size can make a difference. Economies of scale allow larger companies to reduce the impact of fixed costs by associating them with (“spreading them over”) much larger sources of potential revenue. Larger firms also have greater potential to achieve more stable revenue streams through business diversification and in this regard, it’s not just the old-time diversification-for-its-own-sake conglomerates; if one were to study formal 10-K business descriptions, it will become apparent that even many supposedly single-industry firms have far more varied revenue streams line-of-business database codes can depict.

• This plays out in asset allocation as well. The upside potential of most debt securities is limited by the contractual obligation to pay interest and the face value at maturity. Viewed one way, however, debt may look extremely risky since a borrower can go bankrupt and a creditor wind up losing 100% of the investment. But such occurrences are not assessed in isolation. Also considered is the probability of occurrence (which can be zero for government debt or extremely low for investment-grade debt) and the impact of holding debt in a diversified portfolio, where default may have a severe impact when it occurs but may occur so seldom in the context of a portfolio as to make the overall loss very modest. So fixed income is like stocks in that the extent of potential losses/gains is determined by fundamental characteristics (in the case of debt, by credit risk, interest-rate risk and in the case of foreign bonds, currency risk).

Strong upside potential combined with modest risk is a commonplace dream scenario. And at times, revenues may unfold in a way that allows statisticians to demonstrate that it has been achieved over a specific historical observation period (i.e. a prolonged period of good economic trends). It’s important that you distinguish between luck (assuming good outcomes observed in the past will persist into the future) and bona fide risk management (understanding the factors that cause risk to be what it is and making selections consistent with one’s situation and goals).