easy or hard to predict. Value invested today produces expected value tomorrow. Reasonable people will disagree about the timing or magnitude of return, but the value of any investment ultimately ties back to cash in and cash out.
Think again about the list of investments. The cash in the drawer is there whenever you need it. The bank deposit is usually there, too, whenever you need it. An investor in a loan or bond usually has to wait to get interest and to have principal returned. The cash flow from a stock or other form of ownership depends on the operations of the business.
The timing of cash flows matters. Cash may not be able to buy as much in the future as it can today, so future cash may not be worth as much as cash in the pocket today. The cash in the drawer may be safe, but it may not be able to buy a loaf of bread, a dozen eggs, and a carton of milk at the same price tomorrow. For professional investors at banks or insurers or other funds, cash in a drawer may not be enough to meet future obligations to customers or partners. If prices go up, that is, if there's inflation, then the money in the drawer loses value. Or for professional investors, if customers' or partners' need for return rises, cash in a drawer may not be enough. Timing of cash flow matters because the longer it takes to get the cash, the greater the possibility that the cash loses buying power or falls short of investment expectations. In that case, time truly is money.
Timing matters, too, because borrowers compete for cash over different horizons. Borrowers offer to pay different interest rates over different horizons. The supply and demand for cash leads to a clearing rate at each horizon, often called the real rate of interest.
Cash flow also may not be certain. The borrower disappears or has a run of bad luck and cannot repay. Banks fail. The bond issuer fails. The company falls on hard times. Earnings rise and fall. Laws and regulations change. Taxes go up and down.
The cash flow from an investment can range from stable and predictable down to the last penny to wildly uncertain. Cash flow is dynamic. It is the fingerprint of each investment.
Investors can pack concern about the future value of cash or its uncertainty into a discount rate for each cash flow and add them all up into the discounted present value of any investment.1 That becomes the first unifying, simplifying feature of all investments: present value. Investments with short cash flows and long cash flows, safe cash flows and uncertain or risky cash flows all get summarized in one number: present value. The infinite list of investments gets reduced to an infinite list of present values. The list of present values gets sorted from highest to lowest. Now, perhaps, choosing from the infinite list looks simple. Just pick the best.
Risk Is the Mirror to Return
It may seem that investing comes down to simply choosing the investment with the highest expected return, a single investment that for every dollar going in delivers the most dollars out. It could be the stock expected to appreciate the most or pay the highest dividend. It could be the bond that pays the highest rate of interest. It could be the piece of real estate expected to bring the highest price or produce the most income. It could be gold or silver, wheat or pork bellies, or anything expected to go up in value. Investors have developed ingenious ways to project investment cash flows and then add them up or calculate a discounted present value to compare them all. Investing may seem like a winner-take-all game.
If every investor knew the exact cash flows of every investment, then a winner-take-all hunt through the investment menu would get each investor to the right place. It would create races and anoint winners. Genius would prevail. David would beat Goliath. It would make for great television, valuable tips from one investor to another. It would venerate the hunters that find winning investments.
This is the stuff that makes up most advice on investing. The daily game of covering the markets usually focuses on winners and losers, surprises and disappointments, the new new thing. It is a rich and repeatable story. But it rarely makes for good investing.
It's 1952, and Harry Markowitz, then a graduate student at the University of Chicago, makes a simple observation about the hunt for a single best and highest rate of return: it is an unrealistic way to build a portfolio (Markowitz, 1952). Almost no portfolio ever gets built that way. An exclusive focus on expected return or even on expected discounted return rules out the possibility of holding more than one security—except for the trivial case of multiple securities that all have the highest expected return. The rational investor in a winner-take-all world of returns simply would hold the best security. Any rule that led to an undiversified portfolio with one or even a handful of securities, Markowitz argues, violates both observed investor behavior and common sense. Few things in the world are certain; most are uncertain. A winner-take-all approach to investing was silly in the best case and hubris in the worst. He rejects it.
Markowitz instead focuses on uncertainty or risk. We might like to think the world follows a determined path, but it varies in small and sometimes large ways every day. It is probabilistic. One day dawns clear, another cloudy. Traffic moves quickly one afternoon, slowly the next. Technology advances and a new business replaces an old. Earnings ebb and flow. Buyers' preferences shift.
At any point, the future state of the world is unknown. Some future states may be more likely than others, of course. As the world evolves, the probabilities of some future states rise and fall. And as possible versions of the future come in and out of view, the timing, magnitude, and certainty of investment cash flows change. The cost of living might go up or down over time, the ability of a borrower to repay may change, the prospects of a company will likely vary.
Risk can shape the estimate of expected cash flow and the calculation of present value.2 All else equal, the higher the risk, the higher the discount rate and the lower the present value of an assumed stream of cash flow. A dividend or interest payment that an investor expects with near certainty may get discounted at one interest rate. A payment at risk from earnings or default may get discounted at a higher rate. Risk can enter the calculation of present value, but that does not address Markowitz's critique.
Whether the investor adjusts the expectations of cash flow or adjusts the discounting rate, neither approach on its own suggests any obvious metric other than judgment for choosing the cash flows or the discounting rate. And once an investor choses a set of cash flows and a set of rates, discounted expected return still points to a single best and highest rate of return. The winner is anointed.
Markowitz offers a transformative idea for building a portfolio of risky cash flows, using variance to measure risk: “There is a rate at which the investor can gain expected return by taking on variance (risk),” he writes, “or reduce variance by giving up expected return” (1952, p. 79).
In other words, risk is the behavior of cash flow from the time it starts flowing into an investment to the time it finally flows out. Some investments may produce very reliable, very predictable cash flows. The cash in the drawer has a predictable cash flow. The US Treasury bond has a predictable cash flow. The safest bank deposit does, too. An investment in a start-up company may not. The history of an investment's cash flow should reflect this, and so should expected cash flow. The safest cash flows vary only a little bit and have low variance; the riskiest vary a lot and have high variance.3
Investments with predictable prices or cash flows will tend to offer relatively low returns, and investments with unpredictable prices or cash flows will tend to offer relatively high returns. It's intuitive.
Imagine two companies: one that always pays a $1 dividend each year and another that flips a coin and pays $2 for heads and $0 for tails. Both produce, on average, $1 a year. Both have expected cash flow of $1 a year. If both investments cost the same, most investors
