A bread factory takes on risk by holding the ingredients for bread (which might expire, and cost money to store), paying bakers to make the bread (who might get sick or do a bad job), and on and on. It takes on and manages these risks, and if it is successful it makes enough bread to turn a profit and if not it goes out of business.

That's kind of absurd as a construction. It may be literally true that a bread factory accepts various kinds of risk in the ordinary course of business, but it's plainly not the primary reason that a bread factory turns a profit. Does a bread factory that hedges its future wheat purchases with wheat futures have a lower expectation profit than one which does not?

You can think about arbitrarily risk-neutral enterprises that are profitable. For example, what risk is a residential REIT taking, especially one whose properties are all insured? By contrast, you can look at a business like a casino (or a catastrophe reinsurer), where it is legitimately the case that operating income is predominantly the result of risk-taking. But when you put the two side by side, there is not a huge difference in ROIC (Return on Invested Capital), which you might've expected if profits were fundamentally a risk premium.

"For example, what risk is a residential REIT taking, especially one whose properties are all insured? By contrast, you can look at a business like a casino (or a catastrophe reinsurer), where it is legitimately the case that operating income is predominantly the result of risk-taking."

If you actually believe that a residential REIT is zero-risk and a casino is high-risk but they have the same ROIC, you should buy REITs and short casinos and you can make a big profit. That illustrates why there's probably a flaw in your understanding (though not necessarily! you might be able to make a big profit!). The market should have the same logic, and if this is actually true, REITs will be bid up and casinos bid down until the ROIC on casinos is higher than on REITs, appropriately compensating investors.

FWIW, REITs face a lot of significant risks, eg. a regional downturn could lead to all the workers becoming unemployed and vacating or not paying rent, or a rise in interest rates could increase financing costs, or rent control might be enacted and prevent the property management from raising rents as much as financial models predict. And casinos are actually much less risky than assumed: most gambling games have statistical models for how much they pay out, and with millions of games played reality tends to approximate the models very closely (due to the central limit theorem), and they tend to take out insurance on extreme black swan events anyway. I don't know the ROICs on either of these industries in detail, but I suspect that if it's similar, it's because the actual risks to them are similar.

> If you actually believe that a residential REIT is zero-risk and a casino is high-risk but they have the same ROIC, you should buy REITs and short casinos and you can make a big profit. That illustrates why there's probably a flaw in your understanding (though not necessarily! you might be able to make a big profit!). The market should have the same logic, and if this is actually true, REITs will be bid up and casinos bid down until the ROIC on casinos is higher than on REITs, appropriately compensating investors.

No, the return on an investment security (in this case, a share of publicly traded stock) is different from the return on a dollar actually invested in the underlying business (i.e., ROIC). This has a lot to do with the price action that you outline.

The rest of your comment deals with why these are bad toy examples, which is fine but not really all that interesting in context.

The security reflects how investors expect the ROIC of the underlying business to change over time, hence the "risk" aspect. They're forward looking over the life of the security's cash flows, while the company's financials now are a snapshot in time.

You're still confused. The EMH is understood to imply that securities prices are the NPV of future cash flows (or more specifically their best estimate, using all public information), but that has nothing to do with ROIC.

(As an aside, the EMH is obviously false and you don't need to look any further than meme stocks for evidence, but anyway)

For example, suppose you have two businesses, both of them have a future cash flow NPV of $1 billion. However, one of them was started in a garage with $1 million of angel money. The other one is a "fallen unicorn" that got $500 million of VC money before it finally IPOed.

The ROIC of the first company is obviously going to be something like 500x the second, but this is irrelevant to their market caps, which should be the same in textbook-EMH-land, ceteris paribus.

"Does a bread factory that hedges its future wheat purchases with wheat futures have a lower expectation profit than one which does not?"

To the extent that it hedges them rationally, they have exactly the same expectation profit. But the bread factory that hedges its future wheat purchases has a lower real profit than the one that does not, assuming the price of wheat doesn't go up, because buying those futures contracts costs money. That's what it means to turn risk into money: if you are willing to bear the costs of things turning out poorly, you can avoid the costs of avoiding the chance of things going poorly, and increase your profit by the same amount.

I think in general the transaction costs associated with hedging wheat price risk are so small via futures (0.05% or less) that it proves the larger point that profits cannot possibly be due principally to assumption of risk.

Your question about what futures is weird. Yes? It does have a lower expected profit? But a mitigation of downside risk. You seem to think the answer is "no."

That's because the answer is 'no', unless there's an underlying reason to expect that the expectation price of wheat will be less in the future. The only impact to profits is the actual transaction cost of the wheat futures, which is de minimis.

Since this is what you think, you should definitely go into some kind of real inventory heavy business and use futures to hedge against all your inputs going up in price. It'll be a real competitive advantage for you, since you seem to think it's all upside.

A lot of businesses actually do hedge their inputs, this is not a crazy idea I've just come up with. For some industries it's de rigeur (jewelers typically hedge even the value of their inventory and WIP), in others it seems to be a matter of preference (jet fuel for airlines). That's perhaps the single biggest justifying reason for the existence of commodity futures in the first place -- because producers and consumers want to reduce price risk. Agreeing on a fixed future price achieves that goal for both parties. Why would either the producer or the consumer need to pay anything to reach such an agreement? Why would it reduce expectation profits for either party? The futures markets simply provide a low-friction venue.

I agree that lots of businesses do hedge their inputs! Just as lots of people buy insurance. Reducing catastrophic downside risk of something is indeed worth a loss of expected value. But insurance has negative expected value, just like hedging their inputs. If you believe that it's costless or near-costless to hedge your inputs, you should do it literally everywhere to everything that you possibly can, and anyone who doesn't is just leaving money on the ground for you to pick up.

And while lots of businesses do hedge their inputs to some degree, it is not the case that everyone does it to the maximal possible extent.

> If you believe that it's costless or near-costless to hedge your inputs, you should do it literally everywhere to everything that you possibly can

... no? Just because you've eliminated price risk doesn't mean you've eliminated holistic market risk. For example, suppose you're an airline: if fuel prices go up, and your competitors are not hedged, it's no big deal if you're not hedged, because everyone just increases ticket prices. But suppose you ARE hedged, and your competitors aren't, and fuel prices go down, and your competition cuts ticket prices, and... uh, you're screwed, because 1) you have a bunch of fuel locked in at the higher price, and 2) nobody wants to buy your tickets with the old fuel surcharges. So you're forced to take a loss, and the hedge hasn't actually reduced business risk in this scenario. It tends to depend on the game-theoretic context whether hedging commodity inputs actually reduces systematic risk.

Seriously, hedging price risk in commodities is nearly costless, decisions not to hedge almost never have to do with the actual cost of the hedge. In the real world where things are much more complicated than a toy example, many airlines do some hedging, with the aim of reducing sensitivity of profits to short-run volatility in oil, rather than trying to truly eliminate exposure to fuel prices. But that does come as a "free lunch".

This and the responses should be required reading for all the folks who claim that the free market requires perfect information. Well done!

Efficient markets require perfect information. Free market is nowhere near efficient.

> Efficient markets require perfect information

No, they don't. I'm wondering where people get these ideas.

From the definition, if you squint a bit at 'perfect'.

Making up your own definitions of things is creating a strawman.

I do not disagree with you, but that's exactly what the author of the blog post emphasizes: focusing on the "risk -> money" is an example of missing the forest for the trees. It's not the company raison d'être (unless you're talking about an insurance), you're just summarizing how a company operates under a very specific lens, the same way you could describe a company as something converting paycheks into human labor. A company makes products satisfying customers: that is its core purpose. Focusing on the process instead of the product is exactly why mega-corporations fail, which was the main point of the blog post.

The bread factory and plumber turn a little bit of risk into a little bit of money. A company like Google or Goldman Sachs turns a lot of risk into a lot of money, if they manage the risk so it pans out, or a lot of risk into losing a lot of money otherwise.

GP's description is actually quite astute. The legal concept of a "corporation" exists solely to pool risk and limit downside; it originally came from shipping voyages in the early age of colonialism, where a significant portion of vessels simply sank with all hands, but one successful voyage would make everyone involved wealthy beyond belief. Basically every business endeavor you do involves some risk, because the future is unknowable. The plumber might fall into the sewers and drown, the bread factory might be contaminated with E-coli and get shut down by public health after getting sued by all the customers it got sick. But certain endeavors, the ones like the plumber or the bread factory, have largely been studied, systematized, and structured to maximize the chance of success. These are low risk, but they're also low reward, because low risk invites lots of competitors. Other endeavors like writing complex software systems or predicting financial markets fail all the time, and that's why succeeding at them is so lucrative.

No, this falsely equivocates risk with innovation and just regular opportunity. It’s not a given that low risk with low innovation required will have high competition. This is especially true the smaller the market.

On the other end of the spectrum, there are very high risk businesses with no innovation and stiff competition (e.g. dealing illegal drugs).

Your argument is just about investment diversity, not about the purpose of a company.

> On the other end of the spectrum, there are very high risk businesses with no innovation and stiff competition (e.g. dealing illegal drugs).

This made me laugh out loud. I'd say drug dealing is one of the most innovative businesses around. At the high level, cartels are constantly inventing new methods of smuggling and money laundering. At a low level, dealers were first adopters for text messengers, crypto messengers, cryptocurrency marketplaces etc. I'd say this makes them more innovative than most startups (who often just re-invent traditional business but done online). Dealers even make profits!

Some dealers do some innovative things sure. But most are just use violence and local neighborhood knowledge to stay hidden.

“Using a burner phone” is a 20+ year old trope and it was pay phones before that. Not exactly innovation.

The people that made crypto currency market places were pretty innovative. The dealers that used them weren’t. They are the equivalent of people who discovered eBay in the 90s. Early adopters, not innovators.

If a market is sufficiently small as to be not big enough for competition, that strikes me as pretty high risk of becoming too small for any players at all. E.g., think of the main street of a small town. My mom lived in a town that had one grocery store, one gas station, one restaurant. All of them were marginal operations. And there were a lot of empty storefronts on the main drag, places that were no longer sustainable and had gone under.

> The bread factory and plumber turn a little bit of risk into a little bit of money.

Plumbers make excellent money, not a "little bit". I don't know about bread factories, but I assume they do well too.

It's relative. A good plumber with his own small business might make half a million a year. A bread factory probably makes in the low millions, if they're anything like the small businesses (eg. box factories, hot tub supplies, auto repair shops) I know. Google makes $60 billion, and Goldman Sachs makes $11B. That's 5 orders of magnitude.

Plumbers and bread factories make good money compared to salaried W-2 employees (even compared to Googlers, sometimes), but this again is a risk/money tradeoff. When you choose to work for a big company, you are trading off the risk that your efforts will be useless vs. a guaranteed payday that lets the company keep all the rewards if they're successful. In software it's trivially easy to make the opposite risk vs. reward tradeoff: just incorporate the company yourself and get acquired, in which case you get nothing if your efforts are unsuccessful but keep the full market value of your product if they are.

This is basic economics. Taking on risk in expectation of a reward sometimes pays money, sometimes risk becomes realized and you lose money. This applies to Google and your plumber in the same way.