RISK AND RETURN:
RESTATING SOME FUNDAMENTALS
FOR VALUE INVESTORS

Part I

15 June 2003

What we do is look for extremes in markets: very undervalued or very overvalued. Austrian theory has certainly given us an edge. When you have a theory to work from, you avoid the problem that comes with stumbling around in the dark over chairs and nightstands. At least you can begin to visualise in the dark, which is where we all work. The future is always unlit. But with a body of theory, you can anticipate where the structures might lie. It allows you to step out of the way every once in a while. So I’d like to put in a plug, not just for the theory itself – as elegant as it is – but for the application of the theory for calling the turn of cycles in the workaday world.

This series of circulars addresses this unfortunate state of affairs. Starting from first principles, it yields conclusions that closely resemble the foundation stones of Graham-and-Buffett value investing – and which are anathema to the contemporary investment mainstream. It shows that

• the price of an asset and its value are not synonyms – indeed, under certain conditions the one can differ greatly from the other;
  
  
• the mainstream’s conception of risk, which equates it with the volatility of an asset’s market price, is absurd (see also Value Investing, Risk and Risk Management);
  
  
• a businesslike mindset, i.e., a strategy of buying an asset at a sensible price and holding it for a period of time sufficient to reap its stream of benefits, trumps a speculative (i.e., market-centred) approach (see also Why Speculation Inevitably Ends in Tears and Buy and Hold: A Response to Today’s Critics);
  
  
• the conventional conception of return on investment, i.e., the percentage change of the price of an asset over some interval of time, is untenable (see also Value Investing and the (Mis)Measurement of Results).

If so, then many major institutional investors have generated meagre results – not just since 2000 but also over other and much longer periods – because their conceptions of key concepts such as risk and return are erroneous (see also Value Investing Versus the Institutional Imperative). Indeed, assessing their actions and results, one is tempted to conclude that particularly in recent years many have not known what they are doing. To cite just one example, consider the article “Why Telstra’s a Real Humdinger” (The Weekend Australian 26-27 June 1999). According to an analyst in Australia’s largest circulation national newspaper, “the growth premium you are being asked to pay for Telstra now does not take into account any of the goodies in the pipeline that are likely to start appearing over the next couple of years. We have a target price of $20 on the stock by 2003, but all that assumes is above average earnings growth and continual expansion in the … price-earnings ratio the market is prepared to pay … The risk/reward profile is better than you will get anywhere else … and the likelihood of Telstra outperforming the market over a longer period is very, very good.”

Unfortunately for prominent and major investors, vocal investors and great numbers of investors, correspondence with current fads, fashion and the prevailing wisdom are no substitutes for clear premises, hard evidence and valid reasoning. Many have not just misconceived the nature of risk but also drastically underestimated it; and possessing a faulty conception of investment return, their expectations have been unrealistically optimistic. A startling and disturbing implication follows from this realisation: the very core of today’s investment mantra, zealously preached in Australian business schools and piously observed by virtually all analysts, brokers, advisers and commentators (as The Australian credulously stated on 7 May “the more risk you take, the more money you make”), is not just false but immensely damaging to investors’ well-being. A restatement (and, from the point of view of the mainstream, reconsideration) of investment risk and return therefore seems to be in order.

Starting at the Beginning: Why Invest?

Two motivations ultimately underlie individuals’ decision to invest. The first is the necessity that one’s capital generate a constant quantity and quality of consumer goods (i.e., a stable standard of living). Alone on his island, for example, Robinson Crusoe must maintain the livestock, boat, fields, paddocks, pens, sheds, livestock, stores, wells, implements and other capital goods that he has painstakingly accumulated. When his boat or shed springs a leak or an implement breaks he must repair it. If his well yields less or no water then he must extend it or dig another. He must also regularly sow, harvest, rotate and fallow his crops – and retain an adequate portion of the harvest as seed for the next season. He must move his livestock from paddock to paddock such that they are not underfed and the land is not overgrazed; he must breed his livestock such that their quality and number remain constant; and when a beast breaks through a fence he must recapture the former and mend the latter. He must do all of these things because if he does not maintain and replenish his capital – if, in other words, he does not invest – then his ability to produce a given quantity and quality of consumer goods will eventually decrease and his material standard of living will fall.

Second, individuals invest because they desire that their capital stock produce more and better consumer goods over time. They invest, in other words, because they desire a higher standard of living. Crusoe assiduously saves, experiments, devises new and better ways of doing things, undertakes calculated risks and thereby increases his stock of capital goods so that as the years pass each hour of his labour becomes more productive. If so then he can either consume more and better goods or enjoy more leisure without sacrificing current consumption. For two reasons, then, and whether or not he lives alone on an island, an individual must invest. He must renew and regenerate his stock of capital at a rate sufficient to compensate for its gradual deterioration over time; and if he desires a higher standard of living then he must also increase his stock of capital.

Time Value, Time Preference and Rate of Return

Given this necessity, how does Crusoe apportion his time between consumption today and the investment activities he believes will enable him to consume in the future? More specifically, what portion of his time and energy does he allocate to the maintenance of his stock of capital versus its growth? An ear of corn, for example, can either be eaten today or saved, sown next year and its fruits eaten still later. Similarly, he can spend an afternoon dozing or repairing a fence. The former yields enjoyment in the present; the latter, on the other hand, is expected to preserve his ability to consume beef – and will likely yield enjoyment in the future.

To what extent, then, does Crusoe save a portion of what he can consume today so that he can continue to consume in the future? To what extent does he sacrifice leisure today so that he can consume more goods or leisure in the future? The answer lies in his time preference and the time value of his capital (for details, see Frank Fetter, Capital, Interest and Rent, Sheed, Andrews & McMeel, 1977, ISBN: 0836206843; Hans-Hermann Hoppe, Democracy, The God That Failed: The Economics and Politics of Monarchy, Democracy and Natural Order, Transaction Books, 2002, ISBN: 0765800888; Murray Rothbard, Man, Economy and State, Ludwig von Mises Institute, 1962, 1993, ISBN: 840212232; and Richard von Strigl, Capital and Production, Ludwig von Mises Institute, 1934, 2001, ISBN: 0945466315; see also The Robinson Crusoe Ethic Versus the Distemper of Our Times). Given assets’ positive time value and individuals’ positive time preference, individuals require an inducement in order voluntarily to forego consumption today and incur the risks (i.e., inflation, default, inconvenience, etc.) that inhere in investment.

...continued in Part II