Risk and Return Part 2: Why you never find $100 bills in the street

Why are there no low risk/high return investments?

Have you ever found a $100 bill in the street?  Probably not. 

Have you ever seen small coins in the street?  You have.

Why is it that everyone finds small coins in the street and almost no one finds $100 bills?  Supply and demand.

1. The supply of $100 bills in the street is much less than the supply of coins in the street, as people are much more careful with their $100 bills than with their coins. 

2. Demand for $100 bills in the street is much higher than the demand for coins.  The first person to see a $100 bill in the street will definitely stop and pick it up, while many people will walk by coins in the street without stopping to pick them up.

   
   

However, the supply of $100 bills in the street is non-zero (as I have found out from asking this question of thousands of people).  Which leads to the next question:  if $100 bills do appear in the street from time to time, why did you never find one?

You never found one because on the rare occasions when a $100 bill appears in the street, someone else always finds it first, not you.  The supply and demand curve for $100 bills in the street ensures this will be the case. 

These same supply and demand forces dictate that there will be no exploitable low risk, high return investment opportunities.  But why exactly?

Where do returns come from?

From the investor perspective, a return is the gain or loss made on an investment.  In the case where an investor makes a gain on an investment and receives a positive return, where does that return come from? 

If an investor is receiving money, that money must have come from somewhere.  It didn’t fall out of the money tree when the investor shook it.  Someone must have been on the other side of that transaction, paying the money to the investor.  This someone is the investee.

In economic terms, we can look at an investment transaction from either side:

1.      The investee is the seller and the investor is the buyer.

2.      The investor is the seller and the company is the buyer.

To simplify, let’s use an equity investment in a company as an example.  The investor gives cash to the company and receives shares in the company.  We can look at this transaction in two ways.

1. The company is selling shares, which the investor buys with cash.  This is the way we ordinarily look at this kind of transaction.

2. The investor is selling cash, which the company pays for with shares. Although this is not the way we ordinarily look at this type of transaction, both ways are equally valid and are economically the same.

   
   
   
   

   

   
   

What is a return?

Since an investment is a transaction where one party is buying and the other party is selling, the return is the price being offered by the seller and paid by the buyer in this transaction.

In an equity investment where the company is buying money and paying with shares, the return is the price that the seller is demanding for their money.  The concept of a price for buying money is not something we encounter every day and can be a bit confusing. 

Everything we buy has a price and that price is denominated in money.  But when companies acquire money, the price is denominated in return.

There are two ways for companies to acquire money:

1.       They can rent money (borrow)

2.       They can buy money (by selling equity)

The price that companies pay to acquire money is called their “cost of capital”. 

Where do prices come from?

You might think that prices are set by sellers, but sellers do not actually set prices, markets set prices.  Sellers can set an initial price, but in the long run, all prices will be determined by supply and demand.

Demand is the quantity of a product desired by buyers at various prices. As the price goes up, demand will usually decrease and as the price goes down, demand will usually increase.

Supply is the quantity of a product that is available for sale at various prices. As the price goes up, quantity supplied will usually increase and as the price goes down the quantity supplied will usually decrease.

Equilibrium Price is the point at which supply and demand meet.

The prices in a market will always adjust to the equilibrium point where supply equals demand.  If demand exceeds supply, prices will go up and if supply exceeds demand, prices will go down.  This is how supply and demand determine price levels in all (free) markets.

In the chart below, the equilibrium price is 5. At all prices below 5, demand will exceed supply, pushing prices up and at all prices above 5, supply will exceed demand, pushing prices down.

Supply and demand in the supermarket

We can see this phenomenon at work in the supermarket, where supply and demand sets the price of a gallon carton of fresh milk with an expected shelf life of seven days.

Imagine that the owner of the supermarket sets the initial price at $5 when he puts the milk on the shelf on Monday.  If by Saturday, he has a lot of milk left, he will most likely lower the price to move the milk off the shelf before it spoils. 

On the other hand, if he had set the initial price at $3 on Monday and he was sold out of milk by Tuesday, he would probably increase the price on the next shipment of milk. 

The price will finally settle at the level that clears all the milk off the shelf before it spoils at the end of the week, which is currently around $4 a gallon in a US supermarket. 

Although the supermarket owner sets the initial price in both cases, market supply and demand adjust the price until it reaches the equilibrium level.

But how does supply and demand eliminate all low risk/high return investments?

The exact same forces of supply and demand operate in financial markets as well as in supermarkets.  Imagine a market for companies where the risk level of each company and the return on an investment in that company are each determined on a scale of 1 to 10, where 1 is low and 10 is high.  These rankings are updated in real time and are known to all investors in the market.

In this market, all companies will offer a return which is exactly equal to their risk level.

For example, Company A with risk level 5 would pay return 5.  If it tried to pay return 4, all rational investors would avoid investing in it, because this investment would be high risk, low return.  An investor who was willing to take risk level 5 could invest in other companies paying return 5, rather than taking the same risk in Company A but only being compensated with return 4. (In real markets, risk is not so easily measured or agreed upon by all market participants, but that doesn’t affect the underlying mechanism).

Investors make it impossible for companies to pay less return than indicated by the company’s risk level.  But what if Company A decided to pay return 6?  Now it is a low risk, high return investment, because it is paying a return higher than its risk level.

Nobody pays more than the asking price

You are shopping in a store where you know you can negotiate prices.  The product you want is on offer in the store for $500.  Do you ever offer $600?

You would have to be crazy to offer $600 for something you could buy for $500.  You might offer $400 but you are never going to offer to pay more than the asking price.

So why would Company A be willing to pay return 6 when they are risk level 5? Remember that for companies, the return that investors receive is the price that the company pays for that investor’s capital. In this case, the investors’ asking price is only return 5, but Company A is offering to pay return 6; exactly what we said no one ever does: the buyer is paying more than the asking price.

The only logical reason for this behavior is that Company A has an immediate and pressing need for capital, so they are willing to overpay to get it fast. A low-risk, high-return investment has appeared.

This appearance raises a new question about our $100 bill in the street. If $100 bills in the street (and other low-risk, high-return investments) do in fact occur sometimes, why do you never find them?

Somebody else finds them first; not you

In this case, investors will guarantee that this opportunity disappears as quickly as a $100 bill in the street. While Company A will never want to pay return 6 when they are risk level 5, Investors will be more than happy to receive return 6 from a risk level 5 company.

As soon as investors see this opportunity, they will flood Company A with capital. As soon as Company A has fulfilled their immediate need for cash, they will reduce their return to 5, because no one wants to overpay for anything unless they have no choice. The low risk, high return opportunity will have been eliminated.

The law of supply and demand wins; investors chasing low risk, high return investment opportunity lose.

To summarize, in an investment market, investors are selling capital and investees are buying capital.  The return that the company is paying to its investors is the cost of capital for the company and the price at which the investors are selling their capital. 

If a company is paying too high a price for their capital (i.e. offering a return that is too high) many investors will be willing to sell them capital at that price.  The supply of investment capital for the company will increase. 

Assuming that the company’s demand for capital does not increase at the same rate, the price that the company is willing to pay for their capital will decline, as this represents a cost to the company.  Lowering the price they are paying for capital means that from the investor perspective, the return on the investment will decrease. 

This process will continue until the investment’s risk and return are correlated.  The forces of supply and demand act inexorably to enforce the correlation between risk and return.  Another apparently low risk/high return investment will have disappeared.  In today’s markets, with near-instant information being transmitted to market participants, this opportunity will have disappeared blindingly quickly.

Just how quickly do these opportunities disappear?

An illustration of just how quickly these opportunities can be erased if they do appear in real markets comes from the world of high frequency trading (HFT).  HFT employs sophisticated algorithms, high-speed computer technology and super-fast data connections to execute a large number of financial transactions at extremely high speeds.

Some hedge funds employ HFT arbitrage strategies to take advantage of situations in which two exchanges are selling effectively identical investment opportunities at different prices.  They can then buy a security on one exchange for the lower price and sell it on the other exchange for the higher price.  This is a low-risk/high-return opportunity except for the risk that the price difference will move adversely in between buying and selling. 

In 2009 Spread Networks, a company in the US, laid 1331 km of fiber optic cable between the Chicago Mercantile Exchange and the NASDAQ data center in Carteret New Jersey at the cost of US$300 MM.  The cables were laid along the straightest possible route between these two points. 

This cable was initially intended to facilitate HFT arbitrage opportunities involving trading futures contracts on the Chicago exchange against the present prices of individual stocks trading on NASDAQ.

The speed advantage that this $300MM cable would offer when it was completed was approximately 400 microseconds (microsecond = one millionth of a second).

The straightest possible route was chosen because if the cables were not laid perfectly straight they could cause delays in the fiber optic signal (which is basically traveling at 66% the speed of light) which were measured in nanoseconds (one billionth of a second).

At each end of the cable, the company’s computers were co-located in the same data centers as the exchanges and in racks as close to the exchange’s racks as possible, to shave an additional few picoseconds (one trillionth of a second) off the time.

In today’s markets, low risk/high return investment opportunities persist for microseconds or nanoseconds or picoseconds.  These are literally unimaginably short time intervals, because it takes at least about 150 milliseconds (150,000 microseconds) for a thought to travel through your brain.

For all practical intents and purposes, then, unless you are a hedge fund with hundreds of millions of dollars to invest in technology, low-risk/high-return investment opportunities do not exist.