Is fear underpriced or overpriced?
as a common attitude
In everyday life - and more specifically in money matters - people
are usually
risk averse (and 
uncertainty averse).It does not just mean that they don't like risky / uncertain situations,
it entails precise types of behaviors that can be identified.
As an example, when people take investment decisions, they ...normally:
- Take more precautions than for routine spending,
thus they do closer investigations, calculations and analyzes of the
pros and cons of the investment.
pros and cons of the investment.
-
And then, if they decide to put money in a risky asset,
it is usually only if they can expect an extra reward.
Although risk aversion is widespread, it is of course not the only possible attitude
as regards
risk taking. Risk attitudes / preferences vary between people.
Cases of risk tolerance or even risk appetite are not that scarce.
Indiana Jones is among us!
They vary also between situations, for example people usually accept more risk
when gambling than when investing. Fun and glamoour at the casino ?
The risk premium as an extra return...
Most people who 
invest want to get an extra return 
from assets
and projects that are seen as risky compared to those considered riskless (*)
invest want to get an extra return 
from assets and projects that are seen as risky compared to those considered riskless (*)
(*) Such as sovereign bonds, considered as highly safe investment ...at least if the issuing
country is considered financially secure, which becomes hard to find (on that issue, see
sovereign bond turmoil).
In other words people want to be paid for taking risks.
We might call this "the price of fear".
For a given asset, the extra return that measures the average risk aversion for all buyers
and sellers is called the risk premium (or equity premium in the case of stocks).
For example
* If the long term rate for safe sovereign bonds is 5%
* And the equity average return is 11%
=> then the equity premium is 6%.
(this is a approximative calculation, in fact what should be used are compound rates,
but let us not complicate things)
and sellers is called the risk premium (or equity premium in the case of stocks).
For example
* If the long term rate for safe sovereign bonds is 5%
* And the equity average return is 11%
=> then the equity premium is 6%.
(this is a approximative calculation, in fact what should be used are compound rates,
but let us not complicate things)
...and a lower price
In practice, a better return, between two assets that bring similar incomes (*)
means a lower buying
price as
means a lower buying
price as Return = Income / Price
A return risk premium is thus equivalent to a price discount.
(*) once those incomes are corrected by their probabilities as seen in the stock valuation
article.
article.
Some paradoxes
1) Calibration ambiguity
This premium is not so easy to measure, as
- It depends on investment revenue previsions (expected cash-flows),
over a long period normally.
This is because the premium is a difference between the projected
return and the effective return of the asset at its current market price
This is because the premium is a difference between the projected
return and the effective return of the asset at its current market price
- Also the premium varies
("fluctuates") a lot
between bullish and bearish market periods as seen below.
And nobody really knows what should be its ideal average level, for stocks
for example.
What about an average bonus of 6% added to a sovereign bond return as
shown in the above example?
And nobody really knows what should be its ideal average level, for stocks
for example.
What about an average bonus of 6% added to a sovereign bond return as
shown in the above example?
- But this fluctuation of the preium is only apparent when
low or high prices show low or bad price expectations
rather than high or low risk aversion
rather than high or low risk aversion
2) Excesses and illusions can distort the scheme further
Actually, as already mentioned, the risk premium is highly variable, which can
be linked to market trends.
be linked to market trends.
- In
bullish periods it can even become negative.
Then people speculate on risky assets (while tending not only to overvalue
their potential return but also to forget that they are risky).
Those assets become dramatically overpriced, which backfires in the end
(dotcom craze, subprime crisis).
their potential return but also to forget that they are risky).
Those assets become dramatically overpriced, which backfires in the end
(dotcom craze, subprime crisis).
- In
bearish periods, asset buying becomes scarce.
Therefore assets become underpriced as the few buyers on the market
want huge premiums.
want huge premiums.
3) 
Long term vs. 
short term ambiguity
Some assets (stocks, real estate) are considered among the safest and most
rewarding (*) (**) in the long term.
At least historical statistical studies have shown this.
For those assets the real risk is usually in the short term (price volatility),
and it tends to average out in the long term.
But even investors with a long time horizon are sensitive to short time bad
surprises, which is understandable.
Therefore volatile assets still usually show a high premium...
...except when the general exuberance / optimism gets contagious as seen above.
rewarding (*) (**) in the long term.
At least historical statistical studies have shown this.
For those assets the real risk is usually in the short term (price volatility),
and it tends to average out in the long term.
But even investors with a long time horizon are sensitive to short time bad
surprises, which is understandable.
Therefore volatile assets still usually show a high premium...
...except when the general exuberance / optimism gets contagious as seen above.
(*) Not individually, but in an average, in an "efficiently diversified
portfolio".
(**) Another thing is to define "long term", as there are gloomy periods for
stocks that can exceptionally last for one or several decades.
4) Loss aversion can override risk aversion
People hate losses so much that they would often prefer to stay invested in assets on
which they lose money, hoping (often vainly) that the price of those lame ducks will
recover.
which they lose money, hoping (often vainly) that the price of those lame ducks will
recover.
=> Actually, they take the risk that the price will sink further, as there might
often be a good reason why the market does not like that asset.
This is related to the prospect theory, a key concept of behavioral finance, that states
that usually people feel much more pain at losing 100 Euros (or dollars, or whatever)
than pleasure at gaining 200 or even 300 (Euros...)
that usually people feel much more pain at losing 100 Euros (or dollars, or whatever)
than pleasure at gaining 200 or even 300 (Euros...)
Reference and further readings
From Peter Greenfinch's Behavioral finance glossary
and more specifically , extracted from the risk attitude and risk premium
articles in this glossary.
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