Investing is a careful balance between illusion and optimism. All too often we look to the past to forecast the value we’ll see in the future even though it really can’t tell us anything anymore.
When I began my sophomore year as a Finance major at university, I took my first Introduction to Investments course. One of the fundamental concepts the class had to learn about stock market investing was the idea of the Expected Return on Stocks.
When we make an investment in anything, we expect to be compensated for two things- the risk we take by putting our dollars into the unknown and the opportunity cost of no longer being able to take those dollars and guarantee a return in a “riskless” investment. Enter the Capital Asset Pricing Model, or CAPM. This equation is the holy grail of equity investing:
Expected Return on a Stock = Risk Free Rate + [Stock Risk Multiplier * Expected Return on the Market above the risk free rate)]
Why is this equation the holy grail? Because it’s a painfully simple way to characterize complex sentiment. To figure out how much return you should expect on Tesla for example, just plug in a risk free rate from the 10-year US Treasury Bond, pull the Stock Risk Multiplier from Yahoo Finance, and Google search the expected return on stocks from the last 50 years.
What does any of this have to do with illusion and optimism?
The US Treasury is near an all-time low, the return on the stock market is deeply compressed, and estimating the risk of a company only on history is a fool’s errand to feeling safe. The past can’t perfectly predict the future and we need to come to grips with a new era of compressed returns.
We know where the risk free rate stands today, but geopolitical events can shock governments and change the money supply. Just because Tesla did well in the last few quarters doesn’t necessarily mean sales are going to move forward as planned. The market may have returned an annualized 10% year-over-year for the last 50 years, but we just came from one of the greatest two decades for human achievement and it could be a long time before we ever see an explosion of growth and information again.
The world is changing, and we need to think differently so we don’t fool ourselves into thinking that the past can predict the future.
Jack Bogle, founder and former CEO of Vanguard (ever heard of the Index Fund?) wrote a book in 2011 to warn investors of market illusions. We look at a time before the Global Financial Crisis (GFC) and see high profile criticism of the way we did business. WorldCom and Enron with their high-profile accounting scandals. Bernie Madoff and his infamous ponzi scheme. Complex financial instruments dominating firms that boasted double-digit returns (I’m looking at you Metelgeschellshaft and Long Term Capital Management.)
Gamma View 