Links For Further Reading

The temptation is to think that if risk and reward are correlated—if you can reach for higher returns by selling your investment-grade bonds and replacing them with stocks, or selling your large-cap US stocks and replacing those with wilder emerging market stocks—that all forms of risk-taking are rewarded with higher returns. But this isn’t true: the expected return of a single stock of average volatility is the same as the expected return of the market, but the volatility of one stock, compared to a diversified portfolio, is much higher. And thanks to the relentless math of “volatility drag,” i.e. the observation that you don’t offset a -50% loss until you’ve made a +100% return, the expected overall outcome from this particular form of risk-taking is negative.And there are other forms of unfavorable risk/reward tradeoffs: paying higher fees for exposure to the same asset class, for example, is a straightforward cut to returns with no attendant reduction in risk. In the general risk/reward tradeoff, there are some extreme cases where things don’t work as planned: the longer-term a bond is, the more it’s a bet on interest rates, and the more it’s excess return is compensation for taking interest rate risk. But 30-year bonds don’t get returns quite commensurate with their risk—because when bond portfolio managers want to make a big bet on rates, that’s what they have to bet on.

How can we square these observations with the fact that many investors have achieved great success through concentrated bets on a handful of positions? One obvious answer is that some of them are lucky; “lottery ticket” is an accurate pejorative term for assets and strategies whose risk isn’t commensurate with reward, but lottery winners do exist.However, there’s a subtler answer…

There are many mediocre tradeoffs between risk and reward, where you can get the same mix of them in different amounts. And there are some bad tradeoffs available, with incremental-reward-free risk. To get a good tradeoff, you need a good reason to expect it: some justified belief that there’s a particular asset that’s mispriced, and a good meta reason to think that nobody else has considered it. In a competitive market, you need not just a theory about the asset in question, but at least some kind of theory of why your competitors haven’t spotted it. Yes, “I’m a better investor than they are” is a theory—but do any of your competitors pick stocks despite consciously thinking they’re bad at it? Especially in an environment where cheap index funds are available, you should assume that the average market participant is about as self-confident as you are. And one fun implication of this is that the best returns accrue to people who think they’re less skilled than the average stock picker, but skilled enough that they shouldn’t leave the whole process up to Standard & Poors.Which is not to say that investing by picking a small set of smallish, high-variance companies, watching them like a hawk, and enjoying long-term outperformance with some painful dips is a bad trade. It can be a very rewarding hobby! But the opportunity cost is defined by the average performance of index investing. So stock picking ends up being like many other hobbies: it takes time and effort, and if you’re very good at it and somewhat lucky, you might break even.