To invest is to forego consumption today in order to be able to consume more in the future. The risk one takes when investing is that this goal is not achieved, or that the whole endeavor turns out to be counter-productive to the goal. In other words, an asset’s riskiness derives from the probability that it will cause its owner a loss of purchasing power weighted by the magnitude of such potential loss.
Financial analysts typically use short-term measures of volatility such as beta or standard deviation to describe risk. We reject the notion that volatility is risk because risk must be measured over the owner’s contemplated holding period. Treating volatility as risk is to assume that the investor will be forced to liquidate their position at some random point in time. In short, volatility is only a risk for the short-term investor.
Conversely, we do not consider U.S. Treasury bonds to represent a riskless asset simply because their price does not fluctuate very much, nor do we consider their yield the risk-free rate. In fact, we would consider U.S. Treasury bonds, particularly those of the long-term variety, to represent both very risky and very poor investments at current interest rates. Inflation has the power to erode, potentially severely, the purchasing power of a long-term Treasury holder.
We posit that what investors should consider as a risk-free rate is instead the earnings yield on a sufficiently diversified basket of equities, such as the S&P 500, which currently stands at around 4%. A diversified basket of stocks is, over the long-term, the safest investment one can make. In the 92 calendar years from 1928-2020, there was not a single 20-year period in which the S&P 500 declined, even in real terms.
Though the best investment over the long-term is a basket of stocks, many different baskets can be created from the 3500 publicly traded U.S. companies. Woodbridge’s portfolio represents a kind of basket, though a relatively focused one, typically consisting of less than 10 stocks. It might be said that our portfolio is much riskier than the market because it is much less diversified. Such a claim is true. However, we would argue that our portfolio is also much less mediocre than the market.
The weighted-average earnings yield on our portfolio is often more than 10%, meaning that, even if business were to decline for the companies in our portfolio (which are all mostly unrelated), there would be a very large margin of safety before becoming less attractive than the market. Since we believe that the market will be a safe investment over the long term, we believe that a basket of high-quality companies with high earnings yields, even if less diversified, should be similarly safe. Perhaps we have some appetite for risk, but it is a bird-like one: significantly above-market returns for minimal risk is about the farthest we are willing to go.
The reason that we are risk-averse is simple: we have a very long time horizon. Our potential to benefit from compounding over a period of potentially decades magnifies the pain of principal loss. Take for example an investor with 100% of their portfolio in the S&P 500 at year end 1980. If they were to lose $100 of their investment capital by way of some alternate, risky investment, the real cost would be $4,660 of foregone gains by 2020.
Our capital is very precious to us. That is why we do not make bets unless the probability of loss is very low. It is why we do not invest in situations we do not understand, or cannot form a clear idea of the probabilities involved. It is also why we do not use leverage.
Jeff Bezos once asked Warren Buffett why people did not just copy his investment style, given that it was so simple. Buffett replied, “Because no one wants to get rich slowly.” We, however, are perfectly content getting rich slowly with our partners.