CNNMoney recently featured an article headlined “Risk is back”. Was it ever gone?
In 2005, Allan Greenspan gave a speech in which he expressed concern that investors were becoming cavalier about accepting lower risk premiums and therefore paying for overpriced assets. (“Cavalier” is my paraphrasing. He’d never use a word so dramatic as that.) Greenspan continued, “History has not dealt kindly with the aftermath of protracted periods of low risk premiums.”
In finance, risk premium usually refers to the amount (%) over the risk-free rate that investors expect to gain for taking on an investment involving greater risk, such as stocks. The risk-free rate itself is a theoretical construct (nothing is actually entirely risk-free), but in practice, the interest rate on a short-term US Treasury bill is usually used. Both risk-premium and the risk-free rate come into play in the ubiquitous capital asset pricing model (CAPM), which describes the relationship between risk and returns.
Let’s see: the current rate on the 3-month T-bill is 4.8% (as of June 14, 2006). How much do you expect your investments in the stock market to return? Any ideas? How about examining historical returns? Here’s a lovely page from Stern that’s updated regularly showing historical returns on T-bills, stocks, and bonds.
But it turns out calculating risk premiums isn’t an easy task. Depending on the time period you choose, and taking different considerations into account (one of the most important being survivorship bias), you could argue that historical risk premiums in the US lie anywhere between 4%-8%. (Discussing and analyzing historical risk premiums is a very popular topic in finance. Tons of books and papers have been written on the topic, and a Google search of “historical risk premium” results in 10.8M hits!) At current 3-month T-bill rates, this means you should expect to make between 8.8%-12.8% in the market, long-term.
So, is the additional 4%-8% you might make investing in stocks worth their additional risk?
Thinking about this question, many things come into play here, including your level of risk aversion. The problem is that when it comes to stocks, for some reason, many people don’t think of it as real money being used to purchase and sell real assets. Maybe it’s because everything’s electronic now, and 401Ks and IRAs aren’t tangible objects. Or maybe many don’t understand the concept of a owning a company, how to read accounting statements, or what a stock really represents.
Stocks have also historically been used for hedging against inflation, but alternatives in the form of Treasury Inflation Protected Securities or TIPs are also available nowadays.
As you can tell by now, I don’t have an answer to the question I posed above, especially since I still consider myself very much a newcomer to true investing. Perhaps yet again the evidence just supports the boring but time-tested importance of diversifying among the various investment vehicles.