What exactly is a risk premium?

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redcat
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What exactly is a risk premium?

Post by redcat » Mon Apr 14, 2014 1:32 am

I have recently come across this site, and have done some reading regarding the boglehead philosophy. One thing I like is that people on this site take a long term, (relatively) dispassionate view of investing and take great care with costs and long term statistics.

One thing I am having trouble grasping is the significance of the risk premium. If the market is rational, and higher gains for various sectors are just a form of compensation for taking on higher risk (a risk premium), then why advocate for a total market index fund?

What I mean is this:

1) If risk is bad, and people want their money to be protected, then a 100% bond (or other "safe" investment) makes sense. But very few advocate this for the accumulation stage because returns are so low.

2) So in the long term, over several decades, risk is good, if one can weather the storm. By good, I mean likely to give a higher return over the long term. Therefore, a 20 yr old would do well to invest primarily in stocks if he or she has the discipline to stay the course through a 50% loss. Over the long term, equities are likely to bounce back.

3) Index funds make sense because management fees are low. If the market accurately prices risk, then any management fees become a drain on your portfolio (ie you are paying x + management fee for only x amount of risk).

4) By buying a total market index fund, you are taking on the risk profile of the entire market. But individual parts of the market can have higher or lower risk. For example a low volatility index would likely have lower risk but lower long term returns (and thus a lower risk premium). But small cap, single sector, small country markets, etc can have higher returns for higher risk.

5) Why then, should a disciplined 20yr old buy a total market fund? If they are willing to risk (say) an 80% loss with a risky asset class, wouldn't the high risk premium increase the likelihood of a dramatic rise in the future as well? So that investing in a risky asset class would give higher returns over, say, 50 yrs? If not, then why invest in stocks at all? If higher risk is not statistically rewarded over the long term, then why not advocate 100% bonds?

6) The crux of my question is this: if one prefers a whole market fund to bonds, t-bills, etc, then why not prefer a high risk asset class over time instead?

larryswedroe
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Re: What exactly is a risk premium?

Post by larryswedroe » Mon Apr 14, 2014 8:03 am

First, the risks are very different for small and value stocks, Here is list I've presented before if you're interested in the research on trying to find the explanations for the premiums
1.Baruch Lev and Theodore Sougiannis, “Penetrating the Book-to-Market Black Box,” Journal of Business Finance and Accounting (April/May 1999).
2.Robert F. Peterkort and James F. Neilsen, “Is the Book-to-Market Ratio a Measure of Risk?” Journal of Financial Research (Winter 2005).
3.Maria Vassalou and Yuhang Xing, “Default Risk in Equity Returns,” Journal of Finance (April 2004).
4.Xinting Fan and Ming Liu, “Understanding Size and the Book-to-Market Ratio: An Empirical Exploration of Berk’s Critique,” Journal of Financial Research (Winter 2005).
5.Howard W. Chan and Robert W. Faff, “Asset Pricing and the Illiquidity Premium,” The Financial Review (November 2005).
6.Charles Lee and Bhaskaran Swaminathan, “Price Momentum and Trading Volume,” Journal of Finance (October 2000).
7.Ralitsa Petkova, “Do the Fama-French Factors Proxy for Innovations in Predictive Variables?” Journal of Finance (April 2006).
8. Aydin Akgun and Rajna Gibson, “ Recovery Risk in Stock Returns,” Journal of Portfolio Management, Winter 2001.
9. Gerald R. Jensen and Jeffrey M. Mercer, “Monetary Policy and the Cross-Section of Expected Returns,” Journal of Financial Research, Spring 2002.
10.Gabriel Perez-Quiros and Allan Timmerman, “Firm Size and Cyclical Variations in Stock Returns,” July 1999.
11.Lu Zhang, “The Value Premium.” January 2002, http://papers.ssrn.com/sol3/papers.cfm? ... _id=351060
12.Joao Gomes, Leonid Kogan, and Lu Zhang, “ Equilibrium Cross-Section of Returns, March 2001. http://assets.wharton.upenn.edu/~zhanglu/
13. Moon K. Kim and David A Burnie, “The Firm Size Effect and the Economic Cycle,” Journal of Financial Research, Spring 2002.
14.Nai-fu Chen and Feng Zhang, Journal of Business, “Risk and Return of Value Stocks,” October 1998.
15. Clifford S. Asness, Tobias J. Moskowitz, and Lasse H. Pedersen∗Value and Momentum Everywhere, February 2009.
16. Joachim Grammig, “Creative Destruction and Asset Prices,” March 2011.
17. Jia Wang, Gulser Meric, Zugang Liu, and Ilhan Meric, “The Determinants of Stock Returns in the October 9, 2007-March 9, 2009 Bear Market,” The Journal of Investing (Fall 2011).
18. Nishad Kapadia, “Tracking Down Distress Risk,” May 2010
19. Angela J. Black, Bin Mao and David G. McMillan, “The Value Premium and Economic Activity: Long-run Evidence from the United States,” December, 2009.
20. Nicolae Garleanu, Leonid Koganz, and Stavros Panageas, “Displacement Risk and Asset Returns,” July 2008.
21. Lorenzo Garlappiy and Hong Yanz, “Financial Distress and the Cross Section of Equity Returns,” September 2007

2--There's also psychological risks of tracking error regret if you "tilt" ---ask yourself if you would have held on through late 90s with small value stocks when they dramatically underperformed, like in 1998 when they were down 10% and S&P up 29% (or something like that). TE is a real risk for investors that don't know their financial history and understand that the risks can show up and even for very long periods

3-Every investor is different, facing different ability, willingness and need to take risks, requiring different allocations. And stability of labor capital should be considered
If interested in the subject might read The Only Guide You'll Ever Need for the Right Financial Plan--I go through each asset class and ask important questions to help one decide on whether they should own more or less than the market does of an asset.

Bottom line, we have people in our firm that are young and invest 100% equities and all global SV. And I'm all SV globally but low equity allocation (I'm also 62 and have no need to take risks). And then others have significant tilts to small value but not 100%. It's all personal decision on evaluating what risks you're able and willing to take
Hope that helps
Larry

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tadamsmar
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Re: What exactly is a risk premium?

Post by tadamsmar » Mon Apr 14, 2014 8:13 am

100% in the total market is typically considered the maximum risk appropriate even for a young investor. And it has very low turnover, so the transaction fees are typically lower than sector funds.

If you think you need more risk than, say, a total world market fund, then you would have to buy a risky subset or something,

OutOfCyan
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Re: What exactly is a risk premium?

Post by OutOfCyan » Mon Apr 14, 2014 8:26 am

redcat wrote:1) If risk is bad, and people want their money to be protected, then a 100% bond (or other "safe" investment) makes sense. But very few advocate this for the accumulation stage because returns are so low.

5) Why then, should a disciplined 20yr old buy a total market fund? If they are willing to risk (say) an 80% loss with a risky asset class, wouldn't the high risk premium increase the likelihood of a dramatic rise in the future as well? So that investing in a risky asset class would give higher returns over, say, 50 yrs? If not, then why invest in stocks at all? If higher risk is not statistically rewarded over the long term, then why not advocate 100% bonds?
Thanks to the very low correlation of stocks and bonds, a portfolio of 100% bonds actually has both a lower expected return and higher volatility than an 80% bond/20% stock mix.

It's unfortunate that there aren't more asset classes that have a similar risk/reward profile to stocks with lower correlation. REITs are my preferred alternative, although anything with less-than-perfect correlation helps. Precious metals and commodities are a couple other alternatives.

The only gold I own is my wedding ring and my wife's jewelry; I hold no gold or commodities as an investment, but they can serve a useful purpose -- in small amounts -- in a portfolio where reducing volatility is a major goal.

Professor Emeritus
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Re: What exactly is a risk premium?

Post by Professor Emeritus » Mon Apr 14, 2014 8:37 am

tadamsmar wrote:100% in the total market is typically considered the maximum risk appropriate even for a young investor. And it has very low turnover, so the transaction fees are typically lower than sector funds.

If you think you need more risk than, say, a total world market fund, then you would have to buy a risky subset or something,
No you can use leverage to increase the risk. Some analysis claim that very young investors or those with very long time horizon would benefit from leveraging the risk
(i don't agree, but that is how you do it)

Rodc
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Re: What exactly is a risk premium?

Post by Rodc » Mon Apr 14, 2014 9:00 am

6) The crux of my question is this: if one prefers a whole market fund to bonds, t-bills, etc, then why not prefer a high risk asset class over time instead?
One can do this. You would want to do it in a way that is very low cost and you would want to avoid too little diversification.

In an ideal world you would probably be better off to leverage, and indeed many do in some sense, by borrowing money to buy a house, paying the minimum on the loan so they can invest other discretionary income on stocks. (this certainly has some important differences from investing on margin, may involved getting a free employer match, has tax advantages, etc.)

The thing is for a young investor what you invest in is not nearly as important as how much you invest. By the time you have enough that the specific investments are very important you are likely old enough that you don't want the full risk of 100% stocks.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Re: What exactly is a risk premium?

Post by pkcrafter » Mon Apr 14, 2014 9:20 am

Welcome, good first post. I think answers to your questions have been provided. I'd only add that risk/reward is always a trade-off and it isn't very prudent to take as much risk as possible in the hopes of getting higher returns. Balance is the key. Don't forget what risk means. The risk is you will not get what you thought you would. There is a risk premium for stocks over bonds. Why? There is a higher risk premium for small caps over large caps. Why? Risk does not go away in the long term.

Generally, people true investors take investment risk because they have to. What you are thinking about is beyond that and is much more akin to gambling. Also, people are risk averse.
1) If risk is bad, and people want their money to be protected, then a 100% bond (or other "safe" investment) makes sense. But very few advocate this for the accumulation stage because returns are so low.
I mentioned trade-offs. Holding only bonds runs the risk of not accumulating enough for retirement years. That risk must be addressed by taking on investing risk to increase asset value to a useful level. Having said that, there are smart ways to get the risk exposure--a diversified portfolio containing all three major asset classes (stocks, bonds, cash), low cost, hold long term.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

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redcat
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Re: What exactly is a risk premium?

Post by redcat » Mon Apr 14, 2014 5:20 pm

Thanks everyone, for your thoughtful replies. What I am getting from your responses is that risk is fairly accurately priced in the market, but that few have the tolerance to truly take on a lot of risk. And those that can take on such a high level of risk would do well to take on even more risk through leveraging.
The thing is for a young investor what you invest in is not nearly as important as how much you invest. By the time you have enough that the specific investments are very important you are likely old enough that you don't want the full risk of 100% stocks.
This stood out to me. It seems the risk question is not so important with a long time frame to recover, but that by the time a portfolio becomes significant, there wouldn't be much risk tolerance anymore.

steve_14
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Re: What exactly is a risk premium?

Post by steve_14 » Mon Apr 14, 2014 5:40 pm

redcat wrote:Why then, should a disciplined 20yr old buy a total market fund? If they are willing to risk (say) an 80% loss with a risky asset class, wouldn't the high risk premium increase the likelihood of a dramatic rise in the future as well?
Any TSM stock can go bankrupt in short order, at any time. I doesn't get much riskier than that, at least not in the realm of securities available via mutual funds.

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redcat
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Re: What exactly is a risk premium?

Post by redcat » Mon Apr 14, 2014 7:55 pm

Any TSM stock can go bankrupt in short order, at any time. I doesn't get much riskier than that, at least not in the realm of securities available via mutual funds.
:happy I suppose you are right in that the only way to make ridiculous amounts of money is to hold the "magic" stock of the moment (with the risk of losing it all), but then so is holding the winning lottery ticket.

But a risky asset class or allocation is much less likely to go to 0. If one holds (say) 100 stocks with a lot of risk, what does it matter if 10 disappear completely if one returns 1000% or 20 go up 50%? A bankrupt company may never rebound from 0, but intl small caps (for example), very well might rebound from a deep drop over time.
First, the risks are very different for small and value stocks, Here is list I've presented before if you're interested in the research on trying to find the explanations for the premiums
Thanks a lot, Larry, for sharing this research. Intuitively, it makes sense to my mind to risk a lot (within reason) when one has a long investment time frame. But I haven't been able to figure out how that risk is priced, particularly with small and value stocks. If risk is priced incorrectly, it can end up like roulette, where there is the potential for big wins, but where statistically, one loses to the house over time. I've just started reading some of the articles you mentioned (although some I can't find), and they have been helpful in assisting me to form some insights. I plan to keep reading and make a decision that I think will work for me.

Rodc
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Re: What exactly is a risk premium?

Post by Rodc » Mon Apr 14, 2014 8:07 pm

This stood out to me. It seems the risk question is not so important with a long time frame to recover, but that by the time a portfolio becomes significant, there wouldn't be much risk tolerance anymore.
That was not quite my point.

Say you start by investing $100 a month. A year later maybe you have a little over $1000. The return of a conservative stock bond portfolio might be $50 and a high risk portfolio $100 (if you are lucky, might be minus $500). But that is something like $5-$10 a month compared to the $1000 you are putting in each month.

Later you have $1,000,000 and the monthly return is on the order of $5,000 - $10,000 per month (say). Now the returns dwarf your new investments. Heck you almost might as well give up putting new money in it matters so little.

Since at any time you can change your allocation you are not locked into your first allocation, so it hardly matters if the first year you are 100% bonds or 100% stocks. But later it matters a lot. But later you likely do not have the ability to take on a large amount of risk.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Rick Ferri
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Re: What exactly is a risk premium?

Post by Rick Ferri » Mon Apr 14, 2014 8:16 pm

Thanks to the very low correlation of stocks and bonds, a portfolio of 100% bonds actually has both a lower expected return and higher volatility than an 80% bond/20% stock mix.
Not quite.

Bonds and stocks do not always have low correlation. In fact, during most of the 70s, 80's and 90s they had high positive correlation. Further, the only time and 80/20 portfolio has higher a return than 100% stocks is during a bear market.

Rick
The Education of an Index Investor: born in darkness, finds indexing enlightenment, overcomplicates everything, embraces simplicity.

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Re: What exactly is a risk premium?

Post by larryswedroe » Mon Apr 14, 2014 10:17 pm

Rick, he did not say 80% bonds and 20% stocks have higher return and lower SD than 100% stocks, but that 80% bonds and 20% stocks had higher return and lower SD than 100% bonds.
That's very different. And of course it might not have held in some periods.


What he said is true if you use LT (20 year bonds) and even true for 30/70
1926-13 annualized return/sd
100% bonds 5.48/9.85
80% bonds/20% S&P 6.79/8.83
70% bonds.30% S&P 7.37/9.15


But the shorter the bonds the less this will obviously occur, in fact works at 10% but not 20%
With 5 year Treasury
100% bonds 5.295.66
90% bonds/10% S&P 5.96%./5.42

The same findings held btw in 70-99 for the five year, worked at 10% stock level , and it worked in 70-99 with long bonds at 10 and 20% levels

Larry
But 80/20 its 6.59/5.98

Larry

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Re: What exactly is a risk premium?

Post by larryswedroe » Mon Apr 14, 2014 10:18 pm

redcat
It's priced by looking at value metrics like p/b, p/e, p/cf and p/s
The wider the spread the larger the expected premium

Larry

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Rick Ferri
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Re: What exactly is a risk premium?

Post by Rick Ferri » Tue Apr 15, 2014 8:30 am

Oops! I read that backwards. :oops:

Rick Ferri
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