Finance

03 Apr 2025

Returns vs. Risk Adjusted Returns

April-May 2025

Written By: Nic Lancelotta

Kevin O’Leary, one of the more outspoken Shark Tank personalities on CNBC, likes to quip that investing can be like letting your dog out to run around the neighborhood: Sometimes you are just happy to see him come home. As I reflect on 2024, and the cocktail party braggart (who maybe had one too many) boasting about his impressive 2024 returns, I am reminded that investors often spend too much time focused on absolute returns, without any real consideration for associated risk. All investments, even U.S. Treasuries, have some measure of risk. Smart investing means balancing prospective returns against the commensurate risk.

In 1999, the S&P 500 was chock-full of large technology companies focused on a new and transformative technology, the internet. The Wall Street storyline espoused by those select firms lucky enough to bank these companies was that this new technology was going to change the world. Companies selling into this new industry enjoyed ever higher profit margins and the associated spend was expected to continue unabated. Cisco, Juniper, Lucent and Intel all sold equipment for internet infrastructure, and these companies fetched lofty valuations as a result.

In retrospect, there is no question that the internet was indeed transformative and many of the companies that participated in this wave of change were “real” companies (good businesses/margins/etc.). It is equally true, however, that sometimes new technologies can lead to reckless spending, optimistic valuations and — more pointedly — hubris.

Does any of this sound familiar? When I reflect on the fever pitch around artificial intelligence (AI), I can’t help but be reminded of the late ‘90s. Even though I can envision numerous applications for AI, at the moment, this technology is probably most known for helping students write term papers — a lost art. Meanwhile, valuations of the AI leaders also known as the “Magnificent Seven” — Amazon, Alphabet, Meta, Tesla, Microsoft, Nvidia and Apple — have catapulted well beyond market norms. Indeed, Ven Ram, a Bloomberg cross-asset strategist, recently reported the current market cap of the “Magnificent Seven” is now larger than the combined listed market cap of all equities in Germany, India, Japan and the United Kingdom combined! Perhaps more concerning, these seven companies only have about one-fifth of the earnings of the referenced markets. Nvidia, and its brethren, accounted for approximately 50% of the S&P’s return in 2024. Especially for buyers of S&P cap weighted exchange-traded funds or ETFs, the corresponding valuation and concentration risk is real, significant and growing.

I am not suggesting that AI isn’t a game changer — it may well be — or that the mentioned U.S. behemoth technology companies aren’t poised for continued growth. What I am suggesting, however, is that the risk at current valuations is pronounced, and especially for passive index investors.

After another stellar year of S&P returns, and with a massive contribution from just seven companies, I think the following is a more prudent investor framework: Who is the incremental buyer at these levels?; What are the chances that the current trajectory of earnings persists (think law of large numbers)?; and, most important, what sort of risk am I taking for the associated return?

And with that, I’ll poke my head out the door to see where my dog Norton is … “Nortie, Come!

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