Still Trying to Pick Stock Winners? How Capitalism Works

This post was guest written by Brad Steiman with our partner Dimensional Fund Advisors (DFA) Canada.  (Unlike some of the current thinking in the press,  it deals with how people are rewarded for investing, not at the expense of other people, but as a reward for providing capital.)

It is not necessary for someone to have a lousy investment experience for you to have a successful one. Everyone can win because with capitalism, there is always a positive expected return on capital. The expected return is there for the taking, and as a provider of capital, you are entitled to earn it. That doesn’t mean it’s guaranteed to be positive, but only that it is always expected to be positive.

photo of the Canadian flagRealized returns are uncertain because the market can only price what is knowable. The unknowable is by definition new information. If it is considered bad news, or if risk aversion increases and investors require higher expected returns, then prices will drop.

This is the market mechanism working to bring prices to equilibrium where, based on the new information, the expected return on capital remains positive and commensurate with the level of risk aversion in the market.

The opposite would be true if the new information is considered good news or if risk aversion declines. This is how well-functioning capital markets maintain a strong and pervasive relationship between risk and expected return. There is no free lunch.

But stocks and bonds don’t all have the same expected return. Conventional wisdom says that if you want better returns, you must uncover the limited number of truly outstanding companies. In other words, the stocks and bonds of these “excellent” companies, based on their superior fundamental measures (e.g., return on assets, earnings to price, etc.), should have a higher expected return than the stocks and bonds of “unexcellent” ones. While this implies an “excellent” company should pay a higher interest rate if it borrows money, intuition suggests that lenders will assess the strength and relative riskiness of borrowers and charge the riskier unexcellent ones higher rates. The same concept should apply in the stock market.

The market is a closed system where there must be a buyer for every seller and an owner for every stock and bond. There are no orphaned securities! It is mathematically impossible for investors to collectively limit their holdings to the stocks or bonds of excellent companies, so the riskier companies must offer an incentive for investors to buy (or continue to hold) their stocks or bonds over those of a safer company. The incentive comes in the form of higher expected returns.

The market is not fooled, but rather, rationally pays a higher price for—and accepts a lower expected return from—the stocks and bonds of excellent companies, and vice versa. Therefore, the unexcellent company has what is referred to as a higher cost of capital, which is equivalent to the investor’s expected return.

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