Risk Premium: The Invisible Wage of Taking Risk
Posted August 7, 2013on:
It is well established that investors’ sense of risk reward is shaped by immediate past experience.
However, investing based on immediate past experience is like driving while only looking through your rear view mirror. It’s a disaster waiting to happen.
The proper way to think about risk reward is to see investing as a risk taking occupation. When there are more job openings than job seekers, wages will rise. When there are many job seekers chasing too few openings, wages will be lower. It’s just simple economics.
In academic circles, this wage of taking risk is called risk premium.
During the depths of the recent financial crisis risk was abundant, but risk takers were few and far between. Risk premiums, the wages of taking risk, must have been very high. What happened next? In the five years that followed, the market more than doubled. Whoever took up the job of risk taking was richly rewarded. But alas, risk premium is invisible and most investors are totally oblivious to it. No wonder they tend to quit investing when the going gets tough and the premium is highest. It’s like quitting a job right after getting a killer raise!
Things are quite different now. The stock market is in good shape. In the past twelve months, the S&P 500 has gone up 22.73%. Investors are excited about stock investing again. So you can bet there are more risk takers (job seekers) chasing fewer risks (jobs). It therefore follows that risk premiums (the wages of taking risk) must be lower now!