Mental Model: Investment Return Expectations

(This post assumes you’re familiar with the concepts outlined in the preceding mental model post on how to make money investing)

There are no shortage of people in this world selling promises. Financial advisors sell you promises. Banks sell you promises. If you’re an allocator, asset managers, consultants, third party marketers and cap intro groups all line up to sell you promises, too. Such-and-such returns over such-and-such a time period with such-and-such volatility.

Only rarely are these promises derived through anything resembling deductive logic. They’re almost always based on storytelling and data-mining.

When your financial advisor tells you she can get you 8% (god forbid, 10%) annualized on your US-biased public equity portfolio, what is that number based on? It’s almost always just a historical average. Same with your Fancy Consultant pitching private equity or middle market lending or crypto-cannabis venture capital or whatever other magical strategy happens to be selling well at the moment.

He who builds on historical averages, builds on sand.

There’s no natural law requiring US equities to return somewhere between 8% and 10% on average over 20-year rolling periods. Same with your private equity and middle market lending and crypto-cannabis venture funds. As with everything, you should build up your return expectations from first principles.

For bonds, your expected nominal return* over the bond’s tenor is equal to the starting yield.**

For stocks, your expected nominal return is equal to the starting dividend yield, plus expected growth in earnings, plus any change in valuation (price).

For the remainder of this post, we’ll focus on stock returns.

Remember the two ways to make money investing? You’ve got cash distributions and changes in investor preferences. Dividend yields and expected growth in earnings are the fundamentals of your cash distributions. Multiple expansion, as we’ve noted before, is always and everywhere a function of changes in investor preferences for different cash flow profiles.

Where people get themselves into trouble investing is extrapolating too much multiple expansion too far into the future. When you do this, you’re implicitly assuming people will pay more and more and more for a given cash flow stream over time. This kind of naive extrapolation is the foundation of all investment bubbles and manias.

If you want to be as conservative as possible when underwriting an investment strategy, you should exclude multiple expansion from the calculation all together. This is prudent but a bit draconian, even for a curmudgeon like me. I prefer a mean reversion methodology. If assets are especially cheap relative to historical averages, we can move them back up toward the average over a period of, say, 10 years. If assets are especially expensive relative to historical averages, we can do the reverse.***

Below are a couple of stylized examples to illustrate just how impactful changes in valuation can be for realized returns. Each assumes an investment is purchased for an initial price of $500, with starting cash flow of $25, equivalent to a 5% annual yield. Cash flows are assumed to grow at 5% per year, and the investment is assumed sold at the end of Year 5. Only the multiple received at exit changes.

In the Base Case, you simply get your money back at exit.

In the Upside Case, you get 2x your money back at exit.

In the Downside Case, you only get 0.25x your money back at exit.

Despite the exact same cash flow profile, your compound annual return ranges from -12% to 17.9%. I hope this conveys how important your entry price is when you invest. Because price matters. It matters a lot. At the extremes, it’s all that matters.

Base Case: Constant Multiple
Upside Case: 2x Exit Multiple
Downside Case: 0.25x Exit Multiple

If you’d like to get more into the weeds on this, Research Affiliates has a fantastic primer on forecasting expected returns. Research Affiliates also offers a free, professional grade interactive asset allocation tool. It covers a wide range of asset classes in both public and private markets.

In the meantime, what I hope you take away from this post is that there are straightforward models you can use to evaluate any investment story you’re being told from a first-principles perspective. Often, you’ll find you’re being sold a bill of goods built on little more than fuzzy logic and a slick looking slide deck.



*Real returns for bonds can vary significantly depending on inflation rates. This is a significant concern for fixed income investors with long investment horizons, but lies beyond the scope of this post. Really, it’s something that needs to be addressed at the level of strategic asset allocation.

**Technically, we need to adjust this with an expected loss rate to account for defaults and recoveries. This doesn’t matter so much for government bonds and investment grade corporate issues, but it’s absolutely critical for high yield investments.

***Why is it okay to use historical averages for valuation multiples while the use of historical averages for return assumptions deserves withering snark? The former is entirely backward looking. The latter at least aspires to be forward looking.

Also, if you can establish return hurdles based on your investment objectives, you can back into the multiple you can afford to pay for a given cash flow stream. That’s a more objective point of comparison. Incidentally, the inputs for that calculation underscore the fact that valuation multiples are behaviorally driven. Mathematically, they’re inversely related to an investor’s return hurdle or assumed discount rate.

Mental Model: How To Make Money Investing

In my line of work, I see a lot of client investment portfolios. Very few of these portfolios are constructed from any kind of first principles-based examination of how financial markets work. Most client portfolios are more a reflection of differences in advisory business models.

If you work with a younger advisor who positions her value add as financial planning, you’ll get a portfolio of index funds or DFA funds.

If you work with an old-school guy (yes, they are mostly guys) who cut his teeth in the glory days of the A-share business, you’ll get an active mutual fund portfolio covering the Morningstar style box.

No matter who you work with, he or she will cherry-pick stats and white papers to “prove” his or her approach to building a fairly vanilla 60/40 equity and fixed income portfolio is superior to the competition down the street.

My goal with this post, and hopefully a series of others, is to help clarify and more thoughtfully consider the assumptions we embed in our investment decisions.

So, how do I make money investing?

There are two and only two ways to get paid when you invest in an asset. Either you take cash distributions or you sell the asset to someone for a higher price than you paid for it.

Thus, at a high level, two factors drive asset prices: 1) the cash distributions that can reasonably be expected to be paid over time, and 2) investors’ relative preferences for different cash flow profiles.

What about gold? you might wonder. Gold has no cash flows. True enough. But in a highly inflationary environment investors might prefer a non-yielding asset with a perceived stable value to risky cash flows with massively diminished purchasing power. In other words, the price of gold is driven entirely by investors’ relative preferences for different cash flow profiles. Same with Bitcoin.

So, where does risk come from?

You lose money investing when cash distributions end up being far less than you expect; when cash distributions are pushed out much further in time than you expect; or when you badly misjudge how investors’ relative preferences for different cash flow profiles will change over time.

That’s it. That’s the ball game. You lose sight of this at your peril.

There are lots of people out there who have a vested interest in taking your eye off the ball. These are the people Rusty and Ben at Epsilon Theory call Missionaries. They include politicians, central bankers and famous investors. For some of them almost all of them, their ability to influence the way you see the world, and yourself, is a source of edge. It allows them to influence your preferences for different cash flow profiles.

Remember your job!

If you’re in the business of analyzing securities, your job is to compare the fundamental characteristics of risky cash flow streams to market prices, and (to the best of your ability) formulate an understanding of the assumptions and preferences embedded in those prices.

If you’re in the business of buying and selling securities, your job is to take your analysts’ assessments of cash flow streams, as well as the expectations embedded in current market prices, and place bets on how those expectations will change over time.

Ultimately, as the archetypical long-only investor, you’re looking for what the late Marty Whitman called a “cash bailout”:

From the point of view of any security holder, that holder is seeking a “cash bailout,” not a “cash flow.” One really cannot understand securities’ values unless one is also aware of the three sources of cash bailouts.

A security (with the minor exception of hybrids such as convertibles) has to represent either a promise by the issuer to pay a holder cash, sooner or later; or ownership. A legally enforceable promise to pay is a credit instrument. Ownership is mostly represented by common stock.

There are three sources from which a security holder can get a cash bailout. The first mostly involves holding performing loans. The second and third mostly involve owners as well as holders of distressed credits. They are:

  • Payments by the company in the form of interest or dividends, repayment of principal (or share repurchases), or payment of a premium. Insofar as TAVF seeks income exclusively, it restricts its investments to corporate AAA’s, or U.S. Treasuries and other U.S. government guaranteed debt issues.
  • Sale to a market. There are myriad markets, not just the New York Stock Exchange or NASDAQ. There are take-over markets, Merger and Acquisition (M&A) markets, Leveraged Buyout (LBO) markets and reorganization of distressed companies markets. Historically, most of TAVF’s exits from investments have been to these other markets, especially LBO, takeover and M&A markets.
  • Control. TAVF is an outside passive minority investor that does not seek control of companies, even though we try to be highly influential in the reorganization process when dealing with the credit instruments of troubled companies. It is likely that a majority of funds involved in value investing are in the hands of control investors such as Warren Buffett at Berkshire Hathaway, the various LBO firms and many venture capitalists. Unlike TAVF, many control investors do not need a market out because they obtain cash bailouts, at least in part, from home office charges, tax treaties, salaries, fees and perks.

I am continually amazed by how little appreciation there is by government authorities in both the U.S. and Japan that non-control ownership of securities which do not pay cash dividends is of little or no value to an owner unless that owner obtains opportunities to sell to a market. Indeed, I have been convinced for many years now that Japan will be unable to solve the problem of bad loans held by banks unless a substantial portion of these loans are converted to ownership, and the banks are given opportunities for cash bailouts by sales of these ownership positions to a market.

For you index fund investors snickering in the back row—guess what? You’re also looking for a cash bailout. Only your ownership of real world cash flow streams is abstracted (securitized) into a fund or ETF share. In fact, it’s a second order securitization. It’s a securitization of securitizations.

I’m not “for” or “against” index funds. I’m “for” the intentional use of index funds to access broad market returns (a.k.a “beta”) in a cheap and tax-efficient manner, particularly for small, unsophisticated investors who would rather get on with their lives than read lengthy meditations on the nature of financial markets. I’m “against” the idea that index funds are always and everywhere the superior choice for a portfolio.

Likewise, I’m not “for” or “against” traditional discretionary management. I’m “for” the intentional use of traditional discretionary (or systematic quant) strategies to access specific sources of investment return that can’t be accessed with low cost index funds. I’m “against” the idea that traditional discretionary (or systematic quant) strategies are always and everywhere the superior choice for a portfolio.

What sources of return are better accessed with discretionary or quant strategies?

That’s a subject for another post.

Just Own Berkshire?

A friend asks:

Is the portfolio you own with shares of Berkshire Hathaway diversified enough to be your entire equity portfolio?

Here’s my response, with a bit of added color versus my original reply. It’s helpful to have Berkshire’s top 13F holdings (included below) for reference:

Source: Berkshire 13F via

Do I think you could buy today’s Berkshire 13F portfolio and hold it forever as a well-diversified portfolio? No. There’s no such thing as a permanent stock portfolio. Capital markets are far too dynamic for that.

What you’re really buying (and thus have to underwrite) with a share of Berkshire are Warren and Charlie’s capital allocation skills. This is an extremely concentrated portfolio. Not necessarily a bad thing for skilled investment managers like Warren and Charlie. But just a handful of stocks and their idiosyncratic characteristics are going to drive portfolio performance.

Do I believe you could plausibly own Berkshire and only Berkshire as a kind of closed-end fund/ETF managed by Warren and Charlie? Yes, I do. The obvious issue you run into here is that sooner or later Warren and Charlie are going to shuffle off this mortal coil. I suspect it’ll be much tougher for investors to maintain the same level of conviction in their successors.

Would I do it myself? No. It’s an awful lot of single manager risk to take, to just own Berkshire. Even if Warren and Charlie were immortal, it would be a lot of single manager risk to take. However, I could definitely see using Berkshire alongside just a couple other highly concentrated managers, if you’re the kind of investor who doesn’t mind high tracking error and is concerned more with the risk of permanent capital impairment than volatility.

Could you potentially just use Berkshire in place of an allocation to large cap US stocks? Yes, I definitely think you could.

The answer to this question really hinges on your definition of risk, and issues of path dependency in investment performance. In my view, the starting point for any asset allocation should be the global market capitalization weighted portfolio. Deviations from the global market capitalization weighted portfolio should be made thoughtfully, after careful deliberation. Whenever you deviate from the global market capitalization weighted portfolio, you are implicitly saying you’re smarter than the aggregated insights of every other market participant.

Sorry to say, but you’re probably not that smart. I’m probably not that smart, either.

To concentrate an investment portfolio in a single share of Berkshire implies you have a massively differentiated view of where value will accrue in the global equity markets, and that you’re extremely confident in that view. In hindsight, it seems obvious Berkshire would be a great bet. But in financial markets, literally everything seems obvious in hindsight.

Does this mean a concentrated bet on Berkshire wouldn’t work out?

Absolutely not. It just means we need to carefully consider whether a highly concentrated bet on Berkshire makes sense in light of its potential performance across a broad range of possible futures.

Personally, I’m not confident enough in my ex ante stock and manager selection abilities to bet the farm on a single pick like that.

And I think that’s true for most of us.

Ode To Liquidity

When it comes to risk management there is one consideration that towers over all the others. That is liquidity.

The word “liquidity” can mean different things in different contexts. Sometimes it literally means “cash.” Other times it refers to your ability to quickly convert the full value of another asset (like a stock or a mutual fund share) into cash. This post will reference liquidity in both contexts.

Liquidity (“cash”) is the lifeblood of our financial lives. It is the medium through which we move consumption forwards and backwards in time. It is the bridge that links spending, saving and investment.

You don’t fully appreciate the importance of liquidity until you need it and don’t have it.

Poor people understand this intuitively. For a poor person life is a never-ending liquidity crisis. It is the global financial crisis on repeat. There’s a reason the foundation for all financial planning is the net cash emergency fund. The net cash emergency fund is your liquidity buffer. It’s loss-absorbing capital. It’s what keeps you from getting caught in the vicious cycle of dependency on short-term, unsecured, high cost debt like credit cards and payday loans.

Funnily enough, there are plenty of rich people who live life on the edge of a liquidity crisis. Some of these people have a large amount of their net worth tied up in real estate or private business ventures. You can have a lot of paper wealth but still very little liquidity.

When the shit hits the fan, your paper net worth is irrelevant. If you don’t have enough cash on hand to meet your financial obligations, you are toast. This is the story of every banking crisis in the history of finance.

Sure, you can sell the illiquid things you own to raise cash. But that takes time. And the less time you have to sell the worse your negotiating position gets.

There is nothing a shrewd buyer delights in more than finding a forced seller who’s running out of time. This is the essence of distress investing. Distressed investors are often able to buy good assets for fractions of their value because the sellers are desperate for liquidity.

Does this mean you should never own illiquid things?


It means you should never assume you will be able to sell an illiquid thing at a favorable price at a place and time of your choosing.

As an individual, how do you know if it’s okay to own an illiquid thing?

If you can write it down to zero the moment you buy it, and it will not impact your ability to make good on your day-to-day obligations, it is okay to own the illiquid thing from a liquidity standpoint. The thing may still turn out to be a terrible investment, but that’s a separate issue.

These days there are lots of things being marketed to regular folks that are illiquid things disguised as liquid things. These are things like interval funds–the mutual fund world’s answer to private equity. These are also things like non-traded REITs with redemption programs that allow you to withdraw, say, a couple percent of your investment every quarter.

Perhaps your financial advisor has pitched one of these things to you.

Read the fine print!

The underlying assets in these funds are illiquid, and the fine print always allows the investment manager to suspend your redemption rights. Third Avenue Focused Credit investors thought they had daily liquidity, like in any other mutual fund.

Ask them how that worked out.

Pity The Fools

Pity the babies of 1987 and 1990, then, who left school or university around the time that Lehman Brothers collapsed in 2008. Sending around a CV in the middle of the greatest financial crisis since their grandparents were born cannot have been a whole lot of fun.

That’s Tim Harford writing in the FT. As one of those babies of 1987, I can assure you it was indeed hell to send out resumes in the middle of the greatest financial crisis since my grandparents were born.

There are a lot of good articles out there about how your lived experience in markets and the world shapes your behavior. Here’s an especially good one from Morgan Housel.

So how did the financial crisis shape me?

Mainly, it made me paranoid.

It taught me talk is cheap.

It taught me no one’s entitled to a happy ending.

It taught me that money talks and bullshit walks.

It taught me you can do business with people who wield power and influence, you can respect people who wield power and influence, but you should never trust people who wield power and influence.

Most of all it taught me that at the end of the day, the only things you should count on are your skills and your character.

Don’t get me wrong. People can be wonderful. I’ve benefited from the support of many individuals who took an interest in my career development over the years. I will always and ever be grateful for the opportunities they offered me. Particularly in the early days, when I was a poorly-credentialed career changer with the wrong resume.

But here’s the thing about people. You can’t control their behavior any more than you can control the macroeconomy.

It’s Just Business

“Your father did business with Hyman Roth, your father respected Hyman Roth, but your father never trusted Hyman Roth.” – Frank Pentangeli, The Godfather, Part II

Frank Pentangeli is one of my favorite characters from The Godfather movies. He’s a lovable, old-fashioned gangster struggling to eke out a living in a brutal and cynical world. Frank’s fatal flaw is that he’s not smart enough to see all the angles. He never fully grasps how completely he’s at the mercy of forces much larger and more powerful than himself. He clings to a code of honor that seems increasingly outmoded as the plot evolves.

And so, it’s fitting that when Pentangeli finally goes out near the end of Part II, it’s not because someone whacks him. It’s because Tom Hagan convinces him the only way to salvage his honor and dignity is to off himself. The scene is one of the best in all three movies.

In Epsilon Theory speak, Frankie Five Angels is a lousy player of the metagame. (h/t to Epsilon Theory for inspiring this post, btw)


Despite Frank’s obvious flaws, his acute sense of personal honor was useful when it came to judging the character of his business partners and counterparties. His most famous line (quoted above) is a testament to the fact you can always choose to do business with someone at arm’s length. Trust is not a prerequisite for a mutually beneficial business relationship.

So it is with the sell-side.

We do business with the sell-side. We respect the sell-side. But we should never, ever, under any circumstance trust the sell-side.

I was moved to reflect on this after another one of those “market outlook” meetings where a “portfolio specialist” (a salesman with his CFA designation) from a big asset manager comes and talks to you about how the next recession is at least a couple years away* and sure there some risks but nonetheless the fundamentals are sound. Oh and by the way have you looked at leveraged loan funds lately?

Sure, leveraged loan covenants suck, and the space is red hot, and investors will get burned eventually. But there’s still a couple years left in the trade.

Sure, high yield looks like a crap deal on a relative basis, but on an absolute basis there’s still a supportive bid for yield from foreign buyers.

Sure, this stock trades rich, but our analysts can see a path higher from here.

How many times have you heard this stuff? Or stuff that rhymes with this?

Our relationship with the sell-side should always and everywhere be a transactional relationship. But the goal of every great salesman is to turn a transactional relationship into a personal relationship. Personal relationships bring with them all kinds of social conventions and obligations. Unless you’re a complete sociopath, it’s nigh on impossible to behave in a transactional manner once a business relationship turns personal.

That doesn’t mean you can’t go to lunch with the sell-side.

It doesn’t mean you can’t use research from the sell-side.

It means you should never, ever under any circumstance allow yourself to believe the helpful guy or gal from the sell-side you have lunch with once a quarter is truly on your side of the table, always and everywhere with your best interests in mind.

If you do this, and you choose to trust these people instead of merely transacting business with them, you will eventually discover that they do not, in fact, sit on the same side of the table as you. They do not, in fact, suffer like you when the bill of goods they’ve sold you blows up.

And it’ll cost you.

*The next recession is always at least a couple years away.

We Need To Talk About Multiple Contraction

In light of recent market moves I wanted to revisit this post about discount rates and how they might impact valuation multiples (spoiler: it’s an inverse relationship). I think the post holds up pretty well. The key feature was this chart:

Data & Calculation Sources: Professor Aswath Damodaran & Michael Mauboussin

Recall that there’s an inverse relationship between the discount rate and the multiple you should pay for an earnings stream. The discount rate has two components:

1) a riskfree interest rate representing the time value of money (usually proxied by a long-term government bond yield), and

2) a “risk premium” meant to account for things like economic sensitivity, corporate leverage and the inherent uncertainty surrounding the future.

Back in January I wrote:

By way of anecdotal evidence, sentiment is getting more and more bullish. Every day I am reading articles about the possibility of a market “melt-up.” If the market melts up it may narrow the implied risk premium and further reduce the implied discount rate. If this occurs, it leaves investors even more exposed to a double whammy: simultaneous spikes in both the riskfree interest rate and the risk premium. The years 1961 to 1980 on the chart give you an idea of how destructive a sustained increase in the discount rate can be to equity valuations.

I am reminded of this as I read this post from Josh Brown, featuring the below chart:

Source: Bloomberg via WSJ Daily Shot & Reformed Broker

Taken together, this is a fairly vivid illustration of why the current level of corporate earnings matters far less than long-run expectations for margins, growth, and (perhaps most importantly) the discount rate.

(You do remember what’s happening with interest rates, don’t you?)

Assuming no growth, a perpetual earnings stream of $1 is worth $20 discounted at 5%.

Raise that discount rate to 10% and the same earnings stream is worth $10.

Raise it to 15% and the value falls below $7.

And so on.

Now, there’s no way to reliably predict what the discount rate will look like over time. The real world is not as simple as my stylized example. On top of that the discount rate is not something we can observe directly. The best we can do is try to back into some estimate based on current market prices and consensus expectations for corporate earnings.

So, what’s the point of the exercise?

First, I don’t think it’s unreasonable to expect some mean reversion when the estimated discount rate seems to lie at an extreme value. And yes, I counted short-term rates at zero percent as “extreme.” As the above attribution chart clearly demonstrates, multiple contraction can be quite painful.

Second, this should explicitly inform your forward-looking return expectations. Generally speaking, the higher the implied discount rate, the higher your implied future returns. There is good economic sense behind this. “Discount rate” in this context is synonymous with “implied IRR.” To look at a 5% implied IRR and expect a 20% compound return as your base case makes no economic sense. Assuming the implied IRR is reasonably accurate, the only way that happens is if you sell the earnings stream to a greater fool at a stupidly inflated price.

Do fools buy things at irrationally high prices?

Yes. Indisputably. All the time.

Does that make price speculation a sound investment strategy?

No, it does not.

“Multiple expansion” is just a fancy way of saying “speculative price increase.”

Likewise, “multiple contraction” is a fancy was of saying “speculative price decline.”