Exciting Returns May Not Be Expected Returns

It is natural for investors to want more exposure to last year's top-performing market segment. The challenge is determining what portion of that return was a one-off windfall and not something to expect going forward. Viewing expected returns through the lens of cost of capital may help benchmark what constitutes a reasonable expected return from the market.

Companies issue equity and debt, otherwise known as stocks and bonds, to raise capital for investing in and growing their business. The rate of return on these securities depends on both the supply and demand—the return must be sufficiently high to entice investor demand but not so high as to discourage supply by the company, which could otherwise seek alternative sources of funding. The link between these forces means an investor's expected return is the company's expected cost of capital.

This framework may help stave off Fear of Missing Out (FOMO). on an extraordinary return event. For example, the Magnificent 7 stocks grew by 76% in 2023.¹ Even if the concept of expected return is nebulous, does this seem like a reasonable cost of equity capital? How high would borrowing rates have to be for a business to issue stock at that expected return? If the Magnificent 7 companies can secure funding at a lower rate through other means, 76% is not their cost of equity capital, which means it's not an investor's expected stock return.

Asset allocation decisions should focus on the expected return informed by long-term data and analysis. You don't want to bank on the unexpected repeating.

Footnotes

1. In USD. Magnificent 7 include Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla. Named securities may be held in accounts managed by Dimensional. Magnificent 7 return based on monthly market cap weighted average returns. Bloomberg data provided by Bloomberg and calculated by Dimensional.

This article originally appeared Februrary 7, 204 in Above the Fray, a weekly newsletter for clients of Dimensional Fund Advisors. It is republished here with permission of Dimensional Fund Advisors LP. No further republication or redistribution is permitted without the consent of Dimensional Fund Advisors LP.

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