Risk aversion and risk premium

The price of fear

Investors ask for a bonus - in the form of an extra return - to overcome
the fear of risk.
This extra return, when applied to the whole market, is
called the risk premium

Its amount can vary (it can even be negative when investors are exuberant).
The higher the premium, the lower the market price.

How high would you price fear?
Does the market overprice or underprice it?

Risk aversion / uncertainty aversion
as a common attitude

In everyday life - and more specifically in money matters - people
are usually
danger  risk averse (and fog uncertainty averse).

It does not just mean that they don't like risky / uncertain situations,
it entails also 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.
  • And then, if they decide to put money in a risky asset,
it is usually only if they can expect an extra reward.

As regards risk aversion, it is widespread, but is of course not the
only possible attitude as regards
risk 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 glamour at the casino ?

The risk premium as an extra return...

Most people who sous invest want an extra return boite boite   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 gets
      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 of 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 not just add
those two rates but use
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 priceprice 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.

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 hazardous because those expectations might be optimistic
or pessimistic
and the premium is a difference between

- the theoretical return taking into account those previsions
- and the effective return of the asset at its current market
   price.
  • Also the premium varies fluctuation ("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 (the "equity premium").

What about an average bonus of 6% added to a sovereign
bond return as shown in the above example?

  • But this fluctuation of the premium is only apparent when
low or high current prices show low or bad price
expectations
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.
  • In bubble   bullish periods it can even become negative.
Then people speculate on risky assets (and tend not only to
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).
  • In crash bearish periods, asset buying becomes scarce.
Therefore assets become underpriced as the few buyers on
the market want huge premiums.

3) plancalendplancalend Long term vs. clockshort 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.
(*) 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 often prefer to stay invested in
assets on which they lose money, hoping (often vainly) that the price of
those lame ducks will recover.
=> Actually, they take the risk that the price sink further, as there
        ther 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...)

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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M.a.j. / updated : 15 Sept. 2015
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