THERE IS NO SUCH THING AS A FREE LUNCH!

Stocks gave up ground yesterday after investors hoping for data to support larger rate cuts were disappointed. Consumer price growth slowed further but still not enough to convince the Fed to take a long-awaited vacation from MANAGING YOUR PORTFOLIO.

No layups. Can you hear it in my tone? I, like you, would love to receive a special delivery from a mystery sender, post-marked from Washington DC. After confirming that is not a scam, I dream of opening it and reading something like “the stock market is going to go up by +30% in the next 12 months – 100% guaranteed!” Ya, well that’s not going to happen. No, silly, you have to take risk in order to get returns. I hope that this is not a newsflash for you. So, you think you can hack the system and figure out how to take less risk than everyone else and get greater returns? Guess again. I will show you with two very popular investments. The S&P500 and everyone’s favorite stock to talk about NVIDIA. Everyone loves to talk about it because it has returned +188% in the past 12 months! The S&P500 has returned +32%, which is GREAT, but it seems paltry to NVIDIA’s return.

So, wait, why are we even wasting a conversation on this? Isn’t it obvious? Just buy the one that can give you greatest return, the one with the superior track record, right? Uh, no… definitely, no… well, it depends. It depends on just how much risk, or volatility you can handle emotionally and in your budget. I have an admission to make. I was going to write about how yesterday’s CPI number was not bad and that it doesn’t matter that the Fed may only lower interest rates by another -25 basis points before yearend. I was also going to remind you that market conditions have really not changed much in these past few weeks and remind to stay focused on the long term, BUT to pay attention to earnings, because each company will be judged separately based on its individual performance and risk. There, I just said it, so now can we get on with the lecture on the cost of great returns? Let’s.

Recap. So, you want to beat the S&P500, you have to take more risk. If you are happy with the S&P500 returns, and its risks, please, by all means, by the SPY ETF. You know me by now, so I am sure that you are expecting a nifty chart to demonstrate my point. You are right, and here is the chart that I just created in R programming language, exclusively for you, my friends.

Start by looking at the bottom panel of the chart. Here, I compare risk and reward of the SPY ETF and NVIDIA. On the left-hand axis (Y) is the expected daily return based on history, and on the bottom axis (X) is the implied daily move based on the standard deviation of historical returns. You can see that NVIDIA has an expected daily return that is higher than the S&P500 (SPY), +0.27% versus +0.06% respectively. HOWEVER, based on historical volatility, those moves can vary far more widely for NVIDIA than for the S&P500, +/- 3.19% versus +/- 1.12% respectively. That means that on any given day, NVIDIA can be up as much as +3.46%, HOWEVER, and this is really important, it can also be down by as much as -2.92%! Compare that to the S&P500 where, in a single day, it can be up by as much as +1.18% or down by as much as -1.06%, not quite as volatile as NVIDIA.

I know that this is a heavy thing to take in on a Friday, but it is so important and so many people don’t get the concept. So, if you want the potential to make as much as +1.18% in a day but can handle losing as much as -1.06%, your best bet is the S&P500 or the SPY ETF. However, if you crave more, you have to take more risk in something like NVIDIA. With that stock you can make almost +3.5% in a single day… if you have intestinal fortitude to lose almost -3% on any given day. Now apply those bands to your portfolio and decide. Do you want the one that has the potential to beat the S&P500? Are you willing to watch your net worth decrease by as much as -3% in a single day? Before I finish up here, just take a look at the top two panels where I plotted the price charts of SPY and NVIDIA. Those colored bands show just how much better or worse you could have done in each of those stocks on any given day. You may also notice that those bands have gotten wider in the past year. That shows that volatility has increased for both of them over the past 12 months, but you didn’t need a chart to know that.

You probably also know that you can’t beat the S&P500 unless you risk more. By the way, the concept works in the other direction if you want less risk. You can get it, but you can’t expect to get the same returns as the S&P500. So, the message that I want to leave you with today is. please understand what risk you can take before picking an investment based on expected return alone. If anyone tells you otherwise… well, may as well buy the Brooklyn Bridge; I hear that it’s for sale.

YESTERDAY’S MARKETS

NEXT UP

• Producer Price Index / PPI (Sept) is expected to have slowed slightly to +1.6% from +1.7%.
• University of Michigan Sentiment (October) May have improved to 71.0 from 70.1.
• Fed speakers today: Goolsbee, Logan, and Bowman.
• Next week, earnings season ramps up along with housing numbers, Industrial Production, Retail Sales, and regional Fed reports. Check in on Monday to download your weekly earnings and economic calendars so you can be the earliest bird.
• This morning’s earnings: Bank of NY, Fastenal, Blackrock, and JPMorgan Chase beat on EPS and Revenues while Wells Fargo missed on Sales. Much more to come next week, so get your rest in this weekend.

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