Risk-Reward Ratio: a ratio used by investors to compare the expected returns of an investment to the amount of risk undertaken to capture these returns.
THE RETURN
Investing in the stock market in the coming decade promises to be like an Easter egg hunt – in a cage full of angry honey badgers. Yes, you might manage to grab a few plastic eggs filled with tasty jellybeans, but you’ll probably walk away with more than a few flesh wounds.
Until recently, Jack Bogle, the legendary founder of Vanguard Group, argued that equities would provide a nominal annual return of 7% over the next 10 years. This math seemed impossible to me, given rich equity valuations and questions about the sustainability of profit growth. I was actually reassured that Bogle hadn’t fallen off his rocker when he humbly admitted that he has since revised down his estimates.
Previously, Bogle calculated annual return as following: 2% dividend yield + 5% earnings growth = 7% shareholder yield. However, he has since subtracted 3% for a an expected slide in equity valuations to historical norms, for a net shareholder yield of 4%.
Note that this is 4% before adjusting for inflation and before subtracting fees and taxes. If you use a big retail advisory firm using actively-managed funds, your return will be as follows: 4% shareholder yield – 1% advisory fee – 1% mutual fund/stock picker expenses – 1% capital gains taxes = 1% net yield. Adjusted for 2% inflation, this is real return of -1% annually. Yep, only your advisor will be getting rich. You get nothing but fancy account statements and a quarterly phone call (if that).
By using passive index funds for 0.1% and sitting tight, your real returns rise from -1% annually to +1.9% annually. So, use a low-cost advisor or lose your advisor altogether.
THE RISK
In order to capture this 1.9% annual return into our pockets, we have to stomach a lot of volatility. That’s the deal we make when we buy equities. The 10-year standard deviation is about 15% for US stocks and 20% for non-US stocks. No complex math is necessary to figure out what this means. If US stocks follow a bell curve (normal distribution), the returns in any given year during this period we be as follows:
68% chance of a return between -13.1% to +16.9%
95% chance of a return between -28.1% and +31.9%.
99% chance of a return between -43.1% and +46.9%.
But what if the returns don’t follow the bell curve? What if the curve is skewed to the downside and has a fat tail (high probability of an extreme outcome)? When you sit down at a casino slot machine, you are up against a skewed curve with a fat tail that looks like this:
So, as Ned Flanders says, “That’s a dilly of a pickle.” This doesn’t mean we should avoid equities, but we need to do some serious soul searching to be prepared for shallow returns from this volatile asset class.
All hope is not lost. There’s more than one way to resurrect your finances. Sure, we can live on the cheap and religiously invest our shekels in the cheapest way possible, but honestly, a person can only squeeze so much blood from a turnip. Instead, we should find an additional source of income as a more reliable way to fatten our piggy banks. Think along the lines of renting out your guest room on AirBnB, driving for Uber on weekends, tutoring a student through Wyzant, or taking in a dog for a few days on DogVacay. In doing so, we help out our fellow citizens, while also feeding our piggy banks. The only tail risk of this kind of investment is of the canine variety. Happy Easter.
— AK
American Kimchi 