Someone asked me, “what assets can I buy in 2021 to make the most money with no risk”?
If you have followed me for a while, you will understand that this is an incomplete question. You cannot seek advice on what assets to buy without an understanding of what you want to achieve by investing your savings. Your objective and risk profile determine to a large extent the type or scope of returns you will receive from your investments.
For instance, if you are risk-averse, you invest in Bonds that have a very limited upside potential thus your return cannot be expected to be similar to a portfolio that is invested exclusively in equity, which is risker but has higher upside potential. Thus when an investor seeks a return, it’s essentially a bet on investing in a specific asset class or a portfolio of assets.
Let’s briefly talk about returns, There are essentially two types of returns, Absolute and Relative returns. Absolute return is what the asset or commodity returned over a specific period, e.g. if I buy Apple for $100 and the price is $200 twelve months later, then my absolute return is 100%.
There is also relative return which is the difference between what my asset made and the return of the market or a similar index. For example, if I made 100% on my Apple Stock but the return on an index like the Vanguard Information Technology EFT (VGT) returned 10% in the same 12 months, then my relative return or Alpha is 90%.
When an investor is seeking a higher than the market benchmark return, he is said to be seeking Alpha, or a higher relative return. Chasing alpha is risky because the past performance of an asset class in the previous year is not an indicator of future returns. This means if stocks did well in 2020, there is no transfer of profitability, thus stocks are not guaranteed to go up in 2021, We can test this.
Let us assume I was an investor that accepted a higher amount of risk and invested in US equities, Bonds, Emerging Market equities even cash, what would be my absolute and relative return from 2015 to date? Let’s look at the data.
Sourced from various Funds: EEM, SPY, DJP, BIL, SLY, VNQ, AGG, EFA
In 2015, investors would have made an absolute return of 1.3% if invested in a fund that holds Large-Cap equities. Similarly, a -1.8% return in Small Caps, and a whopping -16% loss if he invested in the Emerging Market Equities. That 1.3% absolute would be significant as the world saw in 2015 a global stock market sell-off precipitated by a slowdown in China leading to the Yuan devaluation and a fall in petroleum prices. However, when compared to commodities, the investor made a relative return of over 27%.
What if the investor has decided to selloff his low absolute returning Emerging Market stocks and invest in Large-Cap stocks? Well, he would have incurred the transaction cost of buying and selling his EM stock and missed out as the sectors turned positive, returning an absolute return of 10.9% in 2016.
If the investor was chasing Alpha, he would have sold in December 2016 to buy Small-Casp because of the 26.6% absolute return posted by Small Caps. However, in December 2017, he would have to sell again and invest in Emerging markers which would have returned 37.3%. Then in 2018, he would not invest but hold in cash as the markets all crashed and cash returned 1.7%. In doing this he would have lost the rise in 2019 of Large-Cap stocks which returned 31.32%.
The impatient investor without a plan, but simply chasing Alpha will incur considerable transactional fees from flowing out of one asset class to the other. If the investor had agreed on a plan and simply stayed with equities, he would have returned over ten years an absolute return of 13.8%
The point is this, investing is not done simply to earn a return, investing must be done to meet a stated investing goal, in line with the risk profile of the investors. Expectations must be relative to risk.