Stock Pricing and the Risk Premium


Today we’re continuing with the thread of how to invest for market beating returns.  In this post we will discuss how stocks are priced based on future return and risk.  The introduction of the thread is here:

https://smallivy.wordpress.com/2010/08/31/a-strategy-for-market-beating-returns-in-the-stock-market-introduction/

In investing, a process called “discounting” is often done to determine what price should be paid for things or how much should be invested to obtain a specific amount at a specific date.  For example, if one had a bank account paying 7% and wanted to have  $20,000 in ten years, one could perform discounting and discover that one would need to invest $10,000 today to meet that goal.  In this case the return of the bank account is fairly predictable and there is very little risk involved.  One can therefore expect to get that 7% return and have the needed money in ten years.

Other investments are not as predictable.  Corporate bonds, for example, will pay a predictable amount if they last until maturity – when the company pays the investor the full value of the bond and ends the loan.  Many companies go out of business or otherwise have financial difficulties, however, that cause them to delay repayment of the bond.  Sometimes they default on the bond entirely and the investor is lucky to get a few pennies on the dollar in a bankruptcy.  For this reason investors will expect a bond to pay a higher rate of return than a bank account since in order to be sure of getting the needed return they will need to invest in the bonds of several different companies and make enough from the bonds that make it to maturity to make up for those that fail.  If one were buying 100 bonds, for example, and 5 of them were expected to default, one would need the rate of return to be 5% greater than that of the safer investment.

With bonds, the effective interest rate needed before investors will buy will be based on the length of time before maturity (the longer the time period before the loan is repaid, the more likely it is that the bond will default) and the stability of the company.  This is why the ratings of Moody’s and other rating agencies is so important.  If the rating is low, such that investors are worried the company will default, the company must pay a higher rate on the bond before investors will purchase them.  If the company already has bonds trading in the market and the company’s financial health declines, the price of those bonds will decrease such that their effective interest rate increases.  The price reached will be low enough for investors to make a good enough return to justify the extra risk.

With stocks, the rate of return is even less predictable.  For stocks that have a dividend, there is some added stability since companies are usually loath to cut their dividends so an investor can expect to be getting some return even if the stock price and earnings are stagnant.  If a stock has no dividend, the investor will only get a return if earnings increase.  Because earnings increases are less predictable than the interest rate on a bond, stocks will tend to trade at a discount to the expected future price, due to the predicted earnings, such that the rate of return will be greater than that of bonds should the predicted earnings growth rate be met. 

This additional amount of return is known as the “risk premium.”  The more predictable the future earnings are for the company, the less this risk premium will be.  Companies that are in stable markets, such as utilities, therefore have lower risk premiums than companies in more unpredictable markets, such as biotechs.  One can therefore make a greater rate of return in biotechs, but in buying biotech stocks one takes a bigger risk of not making anything or even losing money.

This additional risk premium is the reason stocks will do better than bonds and other more stable investments over long periods of time.  By buying a basket of stocks, it can be expected that those that survive and thrive will more than make up for the few that don’t perform or even go bankrupt.  Stocks hold a nice place — right in the sweet spot of the risk-return curve.  There is enough risk to allow a good return, but not so much risk that you are more likely than not to lose your money.  Options, for example, are well beyond this sweet spot.  While one can make a lot of money in the options market in a short period of time, you are more likely than not to have nothing within a year.

Next post in series: https://smallivy.wordpress.com/2010/09/07/beating-the-market-investing-long-term-to-reduce-taxes-and-expenses/

See the rest of this series: https://smallivy.wordpress.com/category/making-market-beating-returns/

Much as I enjoy writing about investing, it doesn’t make sense unless people are reading. If you’d like to keep the articles coming, please return often and refer a friendhttps://smallivy.wordpress.comComments are also greatly appreciated, as is lively and friendly debate.  Also feel free to link to or reference posts – all I ask for is fair credit.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

2 comments

    • Long-term I would agree.

      Short term, uncertainty over government spending and, especially, the Cap-and-Trade (carbon credits, global warming) legislation will weigh on the markets. If Cap-and-Trade passes I think the scenario in Atlas Shrugged will become the reality and successful investing will depend on understanding politics far more than economics. I therefore would be buying now on dips, but not with money I need within 5-10 years.

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