Risk Premiums

High returns are the reward for taking high risks. This trade-off is fundamental to all personal financial planning.


Is 4% a good investment return?

The answer is: it depends. In today's (2019) savings environment 4% is an impossible return on a cash deposit, an adequate return for a corporate bond and a poor return for an investment in shares.

Why is this?

Government bonds are the risk-free benchmark

Suppose government bonds (called "gilt-edged stock", or just "gilts") are offering a return of 2%. Since the government guarantees these bonds they are considered risk-free. We say that "the current risk-free return is 2%".

Compare this with a corporate bond

For example, one issued by Widgets plc. It has certain characteristics - an interest yield, a maturity date, a risk of default if Widgets goes bust, and so on. As an investor, would you buy these bonds at a price that gives you an expected return of 2%?

Obviously not - because this is no more than the risk-free return. Why should you take more risk with no reward?

So what is the right price for these bonds?

We do not know. But what we do have is a market price. The many potential buyers and sellers of these bonds, through the wonderful mechanism of the market, find a price that balances the desires of buyers and sellers.

Suppose the market price settles at a level that gives an expected return of 5%. This is 3% above the risk-free return of 2%. This 3% is what the market has decided is the reward or "premium" that investors need for taking on the additional risk of a Widgets bond. It is called the "Widgets bond risk premium".

Is this a good return for a Widgets bond?

Meaning, is 3% an adequate risk premium for a Widgets bond?

Well, that's a judgement call for each individual. It may be not enough for you, in which case you are a seller. It may be fine for me, in which case I am a buyer. So there is no "right" price. But there is a market price - you'll find it online at any minute of a working day.

What about Widgets plc shares?

Would 5% be an adequate return?

Well, no. Any problem with the company and the shareholders get hit before the bondholders. Plus the income from a bond is fixed whereas the dividend income from shares is not. So shares are riskier than bonds. So any investor will want a premium over the bonds as an incentive to buy the shares.

How much premium?

You are probably ahead of us now. All the previous paragraphs on the Widgets bonds apply, and the market will settle on a risk premium that balances buyers and sellers.

Suppose in this case the price of Widgets shares gives an expected return of 8%. We say that the shares are priced at a premium of 3% to the bonds. Or, we say that the shares are priced at a premium of 6% to the risk-free rate (of 2%). We call this an "equity risk premium" of 6%.

How about shares in Fantasy plc?

Fantasy plc is in the business of selling dreams, so the market will find its shares much riskier than boring old Widgets. The market will demand a bigger risk premium than the 6% for Widgets. Maybe 8%, for example, to give a total expected return of 10% on Fantasy shares.

And so on.

And on.

In summary.....

The whole spectrum of investment opportunities is connected by risk premia. The market mechanism ensures that the expected return on Investment X cannot be more than the expected return on Investment Y unless X is perceived to be riskier than Y. Otherwise investors would buy X and sell Y until a reasonable price differential is established.

....and the lesson for savers is...

To get high returns you need to take high risks (or be cleverer than the professionals who dominate the market). High returns are the reward for taking those risks.

Or, if you are not prepared to take risks you cannot obtain high returns.

Investment planning is not about "looking for the highest return". It is about determining what level of return you feel comfortable looking for. It is quite impossible to undertake any investment (other than at random) without facing up to this. But to accept low returns because you feel "safer" without considering the effect on return is as negligent, over the long term, as wild punting in mining shares. Look at Compounding.

 

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