Want big stock market returns? You’ll need to endure the gut-punch drawdowns. There’s no shortcut.
KEY TAKEAWAYS
Many investors are chasing high returns (in crypto, CLOs, AI stocks) without fully understanding the risks behind those returns
The risk-return principle remains immutable: higher returns historically coincide with higher volatility and drawdowns
The recent pullback in major AI/tech stocks isn’t a sign that the macro narrative is broken–it’s the fee you pay for extraordinary gains
Success in long-term investing demands two things: conviction in your thesis and the willingness to endure discomfort
“Free lunch” investments don’t exist: yield, returns, and growth all come with hidden or explicit costs
MY HOT TAKES
Investors have grown complacent with “free upside” because markets have run hard, and that’s dangerous
Chasing high yield in opaque credit (e.g., lower-quality CLO tranches) is symptomatic of the same mindset: reward without perceived risk
If your investment horizon is genuinely long, you should be calm in the current pullback, not panicked
Risk is not the enemy–it’s the mechanism through which return is delivered
Staying vigilant, selective, and disciplined is the difference between capturing full returns and buying into hype
You can quote me: “The gut-punch red days aren’t punishment–they are simply the tolls on the highway to long-term wealth.”
No free lunch. Sorry, no such thing–certainly not on Wall Street at least. Don’t worry, I am resisting the urge to break my no politics rule, and I am going to stick to Wall Street as in investments, and not the physical place Wall Street (IYKYK). I have been increasingly concerned that investors have forgotten some very basic tenets of investing. Many investors have become accustomed to great returns without understanding that they are taking on risk to get those returns. What do I mean? I will give you some tangible examples.
I know many investors who have been vexed by the great possible returns from certain corners of the crypto markets. If you look back at the very recent history in its very short life, you will witness great wealth creation. You can dig as deep as you like and find only great stories that explain why those corners of the market have expanded so rapidly, but alas, nothing in those stories speak of the risks associated with those potentially great returns. Now, to be clear, I am not saying that the potential is there, nor am I saying that those are bad investments, just that investors seem unaware of the risks.
This morning, I read an article about how investors are increasingly seeking out lower-quality Collateralized Loan Obligation (CLO) tranches in search of big yields. In the bond world, spreads between risk-free treasuries and riskier corporate bonds have compressed so much due to high demand and market bullishness, that investors are simply hunting down high fixed-income yields. That chase has now led many people into parts of the market they barely understand.
A CLO is basically a big bundle of corporate loans that gets sliced into layers called tranches. The safest layer, the AAA tranche, gets paid first and takes losses last, so it offers the lowest yield. The next layers (AA, A, BBB, BB, etc.) take on a little more risk and therefore pay a little more interest. At the very bottom is the equity tranche, which takes the first loss if any of the loans go bad. To compensate for that risk, it promises the highest potential return.
It’s no different from cutting a cake: the top slice is clean, neat, and safe, but not as “rewarding.” The lower slices get messier, and the very bottom is where all the crumbs and frosting collect. Some investors are now grabbing for those bottom slices because they see the bigger payouts, not realizing that those payouts are big only because the risk of loss is big. In CLOs, higher yield is never a gift–it’s payment for absorbing the risk everybody else didn’t want.
Let’s get back to equities and markets in recent days. I know plenty of folks who own not just the poster children of AI (NVIDIA, Meta, Alphabet, Microsoft, AMD, Amazon, Oracle, Broadcom, etc), but also a broader array of smaller upstarts with less history–and weaker balance sheets. This has been a fabulous earnings season for those poster children so far. We are obviously not done yet as the mother of all AI stocks, NVIDIA will announce earnings after the closing bell today. Despite the upbeat earnings announcements to date, these AI tech giants have been under considerable pressure, and because they are, structurally, so influential on the broader indexes, large caps, in general have been under pressure, causing the S&P 500 to fall beneath a technical support level after reaching highs just under two weeks ago. This has caused a number of prescient managers to come out of the woodwork and tell us the obvious– that many of those stocks have stretched valuations. Some have reveled in their prowess for having sold all their positions in some of those companies just as they hit their highs. Of course, they have not told you that they also sold last April right near the lows and only got back in at the beginning of Q3. Now, I will step off my soap box and tell you what you need to know if you want to continue to earn great returns in the future, and it all starts with understanding risk. Let’s dig in.
There is nothing exotic or controversial about the relationship between risk and return. It is the foundational principle of investing, yet strangely, it is the first thing investors forget the moment markets wobble. You cannot get the upside without the downside! You cannot reap the gains without enduring the declines. You cannot participate in extraordinary compounding without signs of stress, periods of volatility, and those sudden gut-punch days where everything in your portfolio turns red at the same time. It has and will always be baked into the markets.
I plotted some charts using R language this morning to tell a story that should make it so intuitive, that it almost feels like cheating. I took four well-known, universally recognizable companies and simply plotted their annualized volatility and their 10-year returns. That’s it. No econometrics, no academic jargon, no multi-factor regressions, no models, no assumptions, just ten years of stock price data. Check out the following chart and keep reading.
And what does this scatterplot show? Exactly what every textbook on investing has said for a century: the stocks with the highest long-term returns were also the stocks with the highest volatility. Full stop! Re-read that statement please. 👈The names that gave investors the biggest gains–Apple and NVIDIA–sat on the far right of the chart. The names that delivered lower returns–Coca-Cola and Johnson & Johnson–sat on the left. The line from low risk to high risk sloped upward exactly as you would expect, because markets reward uncertainty. They reward discomfort. They reward the willingness to hold an asset even when every headline is giving you digestive stress. 💨
But for whatever reason, investors keep convincing themselves that they can somehow skip the discomfort part. They want the return without the volatility. They want the upside without the drawdowns. They want the 1000% return without the 50% drop that always, always comes somewhere in the middle. You can show all the historical data in the world, you can create all the charts you want, you can point them to every lesson the market has taught us over the past hundred years, and somehow people will still say, “This time is different.” It is a Wall Street favorite, but I have to inform you, this time… it isn’t different!
I plotted these two charts to underscore the point I am trying to make. Take a look at the cumulative return charts Apple versus Coca-Cola and NVIDIA versus Johnson & Johnson. In both cases, the line that ultimately ends highest–the one that makes investors wealthy over time–is the same line that takes the biggest dips along the way. Apple did not deliver its 10-year 10-bagger by going up every year in a straight line. Quite the opposite. Over the last decade it has served up multiple 20%, 30%, even 40% drops. At the time, each drawdown felt awful, confusing, and… uh, stressful. But in the long run, those uncomfortable periods were simply the tolls on the highway to tremendous gains. 🚀🌕
NVIDIA’s chart is even more striking. The stock that has become the poster child of the AI era, the very stock that investors love to point to as a once-in-a-generation winner, has also produced multiple gut-wrenching collapses. Nearly 60%... twice. Let me repeat that: two separate drawdowns approaching 60%, and yet the long-run return is still astronomical. How many investors survived those drawdowns? How many held on? How many understood the basic fact that the reward comes from the willingness to sit through those volatile periods? Very few. That’s why so few capture the full return of great companies. They get shaken out precisely when the market is charging them the fee for the next leg up.
And this brings us to today. The pullback in the megacap names, which have driven the market for the past year, is not a sign that the bull market is broken. It is not a signal that the AI era is ending. No, the so-called “bubble” is not popping. It is not evidence that the rallies were “fake” or “unsustainable” or “irrational.” It is simply the market charging its fee. It is the price of admission. You cannot have NVIDIA, Meta, Amazon, Microsoft, Broadcom, or Apple double, triple, or quadruple over a few years without periods where they give back ten to twenty percent in a matter of days. You cannot have stretched valuations without inevitable reminders that gravity still exists. Markets inhale and exhale, and if you only want to inhale, you are in the wrong game.
So, let’s ground ourselves in a bit of reality. If your long-term thesis on AI, on cloud computing, on semiconductors, on data centers, on automation has not changed, then neither should your conviction. If your investment horizon is longer than next week’s PCE print, then this pullback is not a threat to your future returns. It is part of the journey. It is the middle, not the end. And if history is any guide, these are the very moments when disciplined, thoughtful investors separate themselves from the crowd.
But do not confuse calm with complacency. Being calm does not mean ignoring risk. Being calm does not mean assuming everything will work out. Being calm means understanding the game you are playing. It means recognizing that great potential does not mean low risk. It means acknowledging that risk is not an enemy to be avoided but rather, it is the mechanism through which return is delivered. And it means you stay vigilant, selective, discerning. You MUST continue to evaluate your holdings, track the fundamentals, and above all, make sure your thesis still holds.
There is no free lunch! Not in fixed income, not in crypto, not in equities, not in AI, not anywhere. If you want the extraordinary long-term returns of great companies, you must be willing to endure the pullbacks that make those returns possible. That is the tradeoff. And that is the discipline that separates investors who achieve their goals from investors who merely chase the next big thing.
Be calm. Be vigilant. Understand the risk you’re taking. And remember: the pullback you’re feeling right now is not a punishment. It’s the price you pay for the long-run gains you want to earn.
YESTERDAY’S MARKETS
Stocks declined for a fourth straight session as investors chose to watch NVIDIA’S earnings today from the sidelines. A less than upbeat earnings announcement from retail giant Home Depot yesterday morning gave investors reason to pause and think about the health of consumers and the still-struggling housing market. Bonds absorbed some of the selling proceeds and 10-year yields eased by 2 basis points.
NEXT UP
FOMC Meeting Minutes from their October 29th meeting will be released at 2:00 PM Wall Street Time. It will be carefully scrutinized to see just how much reticence there is on the committee for further cuts. Powell made it pretty clear through body language that there were hawks hawking about in the meeting. Today we get the ‘deets.
Fed speakers today: Miran, Barkin, and Williams.
Important earnings alert: Williams Sonoma, Lowe’s, Target, TJX, NVIDIA, and Palo Alto Networks.