Lumping it and liking it – with ‘10-K diver
When Warren Buffett says he prefers earning a ‘lumpy’ 12% from an investment to a steady 10%, warns our podcast guest 10-K Diver, he has chosen his words a lot more carefully than most people realise.
As an equity investor, would you prefer a steady 10% annual return or a ‘lumpier’ – that is to say, more volatile – return that might be 12% one year and 8% the next? It is a question that even investment luminaries such as Warren Buffet and Charlie Munger have addressed – but as a recent guest on The Value Perspective podcast points out, lesser mortals need to be very careful how they interpret that pair’s conclusion.
‘10-K Diver’ is the ‘nom de Tweet’ of an otherwise anonymous Twitter account that sets out to explain complex financial and mathematical concepts in digestible and engaging ways. Having attracted almost 250,000 followers in the space of just two years, you would have to say the man behind the account has succeeded and we were delighted to welcome him recently to The Value Perspective podcast.
In Divine answer, we outline 10-K Diver’s take on the difference between two types of investment expectation – the one-off ‘arithmetic return’ and the longer-term ‘geometric return’. And, as the thought experiment known as ‘Shannon’s Demon’ shows, even if the former gives rise to a positive expectation for a stock in the short run, over a longer period of time, the geometric expectation could be zero or even negative.
This idea is particularly important for equity investors because stocks can be so volatile – and indeed the difference between arithmetic and geometric returns is known as the ‘volatility tax’. As we also see in Divine answer, US mathematician Claude Shannon found a neat solution to the problem – which involves constantly rebalancing a portfolio – but here’s let’s focus on the competing attractions of steady and lumpy returns.
Steady v lumpy
Buffett and Munger – the duo behind the Berkshire Hathaway investing powerhouse – are on record as saying they prefer a higher, lumpier return but, warns 10-K Diver, people need to be very careful what they take from that. “Let’s say you have the choice between two stocks,” he continues. “Stock A offers a 10% return every year, like clockwork, while Stock B could return either 8% or 12%.
“The average return for Stock B is still 10% a year but, over a long period of time, there is actually a very high chance Stock A will outperform Stock B – simply because of this volatility tax. And what investors need to bear in mind is, when somebody like Warren Buffett or Charlie Munger makes a statement, they are very careful in choosing their words.
“So, in one of his letters, Buffett might say something like, ‘we prefer a lumpy 12% to a steady 10%’ – and what a lot of people take away from this is all that matters is the return you get and there is no need to care about volatility. But while it is true you would prefer a lumpy 12% to a steady 10%, that lumpy 12% has to be a geometric average, not an arithmetic one. That is the point a lot of people fail to grasp.
“If I had a stock that could double or halve, is that a lumpy 25% return? No, it is a 0% return because, while the arithmetic average is 25%, the geometric average is zero. So when Warren Buffett says he is OK with a lumpy return that is higher than a steady one, what he means is he wants a higher return – after accounting for the volatility tax – and, if that return happens to be lumpy, then he can live with that.”
A related question is the degree to which investors who focus heavily on the fundamentals of a business – on its earnings, cashflow and so forth – rather than broader economic considerations should concern themselves with an idea such as the volatility tax. “There are those who argue you should not care about short-term volatility in the market price of a stock,” acknowledges 10-K Diver but, once again, he advises caution.
“Yes, over a long period of time, stock prices usually follow the fundamental qualities of a business but there is not a single company on earth that can deliver the same return on capital every single year,” he argues. “So there is going to be volatility in the fundamentals as well and, as such, while, you may not be worried about volatility in the market price of a stock, you still have to be worried about volatility in the fundamentals.
“If some years a company earns 10% on capital and other years 20%, that does not mean you will get a 15% return over a long period of time. If you believe, over the long term, its market price will follow its business performance, that is fine – but you still have to care about the volatility. That is because, over a long period of time, the most likely outcome is not the arithmetic average of 10% and 20% but the geometric average.”
Fund Manager, Equity Value
I joined Schroders in 2015 as a member of the Value Investment team and manage the European Value and European Yield funds. Prior to joining Schroders, I was responsible for the UK research process at Threadneedle. I began my investment career in 2001 at Dresdner Kleinwort as a Pan-European transport analyst and hold a Economics degree.
Juan Torres Rodriguez
Fund Manager, Equity Value
I joined Schroders in January 2017 as a member of the Global Value Investment team and manage Emerging Market Value. Prior to joining Schroders I worked for the Global Emerging Markets value and income funds at Pictet Asset Management with responsibility over different sectors, among those Consumer, Telecoms and Utilities. Before joining Pictet, I was a member of the Customs Solution Group at HOLT Credit Suisse.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German, Tom Biddle and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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