The biggest meme in investing
Investing is packed with myths and legends. Here's the one most likely to lead you astray.
From an early age, we get used to the idea that diseases can spread from person to person. Boy and girl germs get passed between kindergarteners in epidemic proportions every day.
Like playground viruses, ideas can spread too. Evolutionary biologist Richard Dawkins was the first to describe ideas as transmissible units, called 'memes', in his book The Selfish Gene. When you read or hear about a good idea, it's natural to want to pass that information on to those around you. Ideas leap from one brain to the next, especially when they make the host feel good or smart for sharing it. The facts tend to get lost along the way.
Investors aren't immune and there's no shortage of investing myths: property prices only go up, gold is the safest asset, great companies always make great investments, you can time the market etc. But there's one catch-cry we probably hear more than any other - risk equals reward. If you want big gains, you need to take big risks.
How we should define risk exactly is too big a topic for this article. Some think of it as uncertainty over outcome; some as the possibility of a permanent loss of capital. For our purposes here, we'll go with the Oxford dictionary's simpler definition: the possibility that something unpleasant will happen; a situation involving exposure to danger. Better to be roughly right than precisely wrong, as the meme goes.
Risk ≠ Reward = Value
Like most memes that are good at propagating, there's an element of truth buried in the phrase 'risk equals reward'.
In general, investors require higher compensation for taking on additional risk - the Australian Government is going to get a better rate on its long-term bonds than Venezuela. The equation also tends to hold when it comes to whole asset classes - stocks are more volatile than property, which itself is more volatile than bonds and cash. A chart of these assets over the past 100 years shows that returns have followed that order as well, with stocks being the top performer and cash the worst.
However, this is where the theory ends. When you're choosing individual stocks or assets, higher risk isn't automatically compensated - it needs to be 'priced in'. This is why speculative stocks like small biotechs or glamourous start-ups can so often lead to dismal returns relative to boring but stable blue chips. Greed can cause investors to actually overpay for the small possibility of huge success - just like people overpay for lottery tickets.
It's important to differentiate between underlying business risk and investment risk, which is dependent on the price you pay. At a business level, a small-cap retailer may have a greater chance of failing than, say, Sydney Airport (ASX: SYD). But if an investor paid $100bn for the airport, they would have no hope of earning a decent return compared to an investor buying the retailer for less than its cash in the tills.
Value investing works because the lower the price you pay relative to a company's intrinsic value, the greater your margin of safety. Risks remain but, with a wide enough margin of safety, the value you're getting more than compensates for them.
What's more, for a fixed set of cash flows, as the price you pay goes down, the return on investment rises. If anything, your exposure to danger and return are two sides of a see-saw: as the share price goes down relative to intrinsic value, the margin of safety widens, and the prospective return goes up. In this sense, risk doesn't equal reward - value does. What matters is the value you get and the price you pay for it.
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