Risk premium is a circular concept? (My theory)
Idk if anyone has noticed this, but going thru many finance textbooks, and they love to all justify risk premia by going: (I'm gonna take the example of the equity risk premium here)
Equities are risky, hence investors require a higher return, hence they demand a premium, THEREFORE equities have a premium. Or they'll say, the equity risk premium is there to compensate investors for equity risk.
What, so if you demand a premium, you'll get a premium?
So why don't all risky assets have premia then? Since investors will demand a premium for risk!
(Quoting from 'Your complete guide to factor-based investing':
The ERP is justified by 3 reasons:
1) Equity risk is correlated with the economic cycle. Therefore, investors demand a premium to compensate for the 'double whammy' of losing their jobs and losing out on stocks at the same time
2) Most equities are owned by HNW individuals. Diminishing marginal utility of wealth. Therefore, equities need to provide a large premium for these HNW guys to invest even more
3) Young guys should theoretically invest in stocks, while old guys shouldn't. However young guys are income-constrained. Therefore equities need to provide a premium to incentivize young guys to invest despite their income constraints.)
This is nuts! This seems to me like putting the cart before the horse. Academics are looking at the historically strong premium that equities have provided, and reverse-engineered in hindsight the risks that this premium encompasses. And it's only cuz these risks are very real and pervasive, that the equity premium will not be easily arbed away, what we call limits to arbitrage. And ig that makes sense, which partly explains why the risk causes the premium = the risks themselves prevent the premium from getting arbed away
But that doesn't explain why it seems like, just cuz investors demand a premium, they'll get a premium!
I've come up with a theory.
My theory as to why investors get a premium, simply because they DEMAND a premium (think about how counter-intuitive that sounds - you get smtg just because you demanded it):
Investors DEMAND a premium. Let's say they require a 4% rate of return on equities. So, any stock that expects a sub 4% return, people wouldn't invest in it on average. This pushes the shitty sub 4% return stocks cheaper and cheaper, until at some point because they're so cheap, their expected return gets higher so they meet investors' requirements again. People invest now.
Conversely, the stocks that expect to deliver a > 4% return, get overcrowded. This pushes these stocks to such an expensive level where their expected returns become trash. Investors shirk these stocks, they become cheap again, and the cycle continues.
So the stocks that investors hold are always the ones which deliver the premium. Since investors, collectively, ARE the market, this explains why the stock market as a whole delivers an excess return and has an equity premium.
Backing out of this overly simplistic scenario, we can imagine a complex market, of supply and demand, consisting of many investors selling stocks that don't expect the required return, and buying stocks that expect the required return. The risk premium is probably the equilibrium point where buyers and sellers agree on the expected return for a given amount of risk (but I don't even fully understand how to imagine this myself). Removing more assumptions, we can even imagine active management as a zero-sum game, in the sense that certain investors lose because they are unskilled therefore they don't even know that certain stocks are not expected to deliver the required return, thus they buy those stocks and lose.
I feel like this cyclical explanation of the risk premium is even analogous to (or can even be explained by, or be a variant of) the Soros theory of reflexivity. 1) It's cyclical shit, 2) Investors collectively sort of form a self-fulfilling prophecy.
This theory can be broadly generalized to other asset classes with empirically founded risk premia, like alts or corporate credit.
Feel like my brain is falling apart again. Is my theory correct? Help!
How high were you when you wrote this?
Yeah, all investors demand a premium for taking risk otherwise they wouldn’t invest in something. If something has a below market return, the price will go down making the yield ultimately what the market dictates it should be. You either were high when you wrote this or not nearly as smart as you think you are…
This seems obvious.
There was some re-"flex"-ivity occurring when he thought he could bend spoons using his mind after sticking one up his nose full of white powder.
Maybe build a dcf or a very basic model before writing random thoughts. It is very clear how the levers work.
Idk if my brain is just not working anymore because I spent all day cranking stuff out, but I couldn't really follow this.
My first take is that sometimes an over-analysis of the academic approaches of financial theory is counterproductive, in that it doesn't really teach us anything useful and we learn far more by just looking at businesses and stocks themselves, rather than musing on philosophies and theories.
Maybe I missed the whole thing but my thoughts: The ERP exists because the time value of money is a thing and we can measure these opportunity costs and uncertainties. More of a byproduct than an input, which might help with this whole circular thing... You don't get a return from the ERP itself, you get a return because you are paying for an asset today that will generate cash flows and because the value of that stream of cash flows may be worth more to another investor in the future (when you sell). Now there are some quants like AQR and Dalio to an extent that measure this stuff to determine optimal portfolio balances when pushing against EMH limits, so if you want to get deeper into it, they have a ton of whitepapers on the stuff. If you are pursuing fundamental though, not sure this road ends up anywhere.
Boy got them runtz
You sound very high like a comment above said
It’s really quite simple . Stocks are more risky than risk free assets ie assets with a pseudo guarantee and because those assets are more risky you need to be paid a premium ie return over treasuries to own them
Not much more to it champ
discount rates reflect opportunity cost of capital, ERP is one tool to measure this cost
Yield on equity isn't certain. Yield on a treasury bond is (or at least as close as you can be to certain). Therefore, you expect a higher return from equity to compensate for the uncertainty of getting said yield.
Imagine I can either give you $1, or let you flip a coin and if it lands heads I give you $1. You would take the dollar. Now, if I offer to give you $1 or let you flip a coin and if it lands heads I give you $3, you might take the chance. You demand a higher yield to compensate for risk. You are in your head about this bro it's not that deep.
Yes.
They do.
This was my exact thought when reading over that line
Think you should see capital markets as a source of capital for businesses and look at the return of the business itself
this will give you the answer you are looking dor
how dare you question risk/return concepts when harry markowitz has just died (r.i.p.)
Investors don't get a risk premium for just demanding it, there needs to be someone on the other side of the transaction that is willing to offer a risk premium as well. For stocks, when they are first issued, the entrepreneur is the one willing to offer the premium. Entrepreneurs sell stock for less than its future expected value because they need capital to grow their business (and usually also want to offload their company's risk to someone who is better diversified). If investors demanded a premium (for the risk they take) and entrepreneurs did not want to offer any premium (i.e is not willing to sell at a discount to EV to compensate for risk) there would be no price for the transaction to occur and the stock would not get issued. Only when there is an overlap in an investor's max price and an entrepreneur's min price can the transaction occur.
Similarly, when investors trade with other investors (most transactions in liquid public markets), it is important to recognize that investors don't only demand a premium when they buy a stock, but they also offer a premium when they sell out of the stock. This is because sellers need liquidity and/or do not want to hold the risk they currently have, and are willing to pay some of their EV to offload that risk to someone else. If investors only demanded risk premiums but never offered any, there would be no risk premium, just an illiquid market with no transactions / no clearing price between buyers and sellers.
Ultimately the dollar weighted average of the risk premium that investors demand when buying and the risk premium investors offer when selling (i.e. demand & supply) determine the quantity of the risk premium, and because both investors demand a risk premium AND entrepreneurs / other investors are willing to offer it, risk premiums exist and we have liquid markets.
Agreed that, on average, the traded price of an instrument will remain lower than the “fair value” ie the NPV of future cash flows. Buyers will only buy for less, sellers are willing to sell for less.
However, the risk premium theory goes one step further and says that the *returns* is positive — ie the average traded price (depressed due to risk perception / liquidity demand) tends upwards towards the fair value. It seems like another ingredient like no-arbitrage is needed. Also, won’t the risk-depressed traded price eventually close the gap to the fair value if the expected returns on that price are positive?
Yes so the accrual of returns is positive because as time passes, some of those expected cash flows go from uncertain / risky to certain / realized, and the cash flow is worth more when realized. Therefore, the price appreciates to reflect that. Then the company either distributes that cash to investors in a dividend (dropping the price / creating room for future return, and the investor doesn’t experience the price decline as a negative return because they collect the dividend) OR they reinvest the cash to create more cash flows, increasing the EV of the future cash flows / justifying the higher price.
To answer your convergence to fair value question, returns can be positive forever without having market caps go to infinity because companies can distribute out cash flows which reduces their market cap without reducing returns.
It’s funny how many (experienced) analysts I interview who don’t understand this, and think stocks go up over time because “the economy grows” or “companies have growing profits” and have even heard “because of the Fed” before. No, stocks go up over time because cash flows that were expected but uncertain become realized. You can have a company whose earnings are expected to decline to zero, whose return is positive throughout as long as it hits its numbers on its expected path to zero.
Just think of it as a hurdle rate instead, it’s more intuitive
It’s an expression of the min IRR required to justify an investment (to chose this specific cash flow of the ‘next best option’)
The most observable / lowest risk option is treasuries - so the risk free rate is a reasonable lower bound and spreads of risk/return above the are sensitive to the baseline ofc
As for estimating ERP, using backward looking returns is just a simplification, using asset class or peer ERP is just simplified comps, imo it’s more important to model bear/bull/base and probability weight it (just another way to capture ‘risk’).
DCFs and ERP are useful concepts for framing but in practice they are just simplifications and usually in practice not used
I also tend on the side the academia is over explained and under practical. But I think this is a better way to think about it:
Why don’t all investors demand a risk premium?
It is more like bidding rather than demanding some arbitrary number that impacts returns. E(R) is inverse to prices so when people sell, it is (usually) because they see more risk in the asset than justified, hence price goes down and mathematically, risk premium increases.
It is a symptom of asset prices rather than a driver. Although academically we view it somewhat differently and impractically.
The cycle is circular to the extent that a momentum strategy will permit. But this is not because stock X has high risk premium, people see high returns, buy it and drive the price up. Instead, momentum is better described as confirmation bias amongst crowds. If stock X wasn’t well covered, and all of a sudden Warren Buffet buys it, it’s intrinsics have not changed, but people will pile in because of the social psychology. Not risk premium.
Hope this helps
Please seek medical attention immediately
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