Thursday, December 30, 2010

Has the Stock Market Gotten Riskier? - Investing - Stocks -

Why are retail investors leaving equities amid strong returns and strong corporate profitability? 

This is a terrific article about the reasons that the stock market should be stalling.  In short, the market has become more volatile, which, in portfolio theory, means that it involves more risk and therefore require a higher risk premium.

The article suggests that valuation shouldn’t be the source of the problem, given that investors were willing to pay more in 2007 for assets that had a lower earnings yield.

Instead, it suggests that the sharp increase in the number of large movement days, up or down, that have occurred in the last 25, 15 and 10 years (2/3rds of extreme price movements since 1950 have been crammed into the last 15 years), has changed investors perspective on the “riskiness” of the market.

Portfolio theory says that assets are priced relative to each other, and that an investor begins with a “Risk-free” rate, one where the exact prices and returns are calculable with 100% knowledge, e.g. a Treasury bill.  Riskier assets should require a higher risk premium to compensate the investor for taking on the additional risk.

Risk is considered to be the volatility around an expected return.  If a Risk Free investment guarantees me 2% (no volatility – I will get my expected return, because the US government WILL make the payments it has promised, when it has promised them), then to hold a riskier asset, one where I could lose money (one possible return outcome is negative) I must be able to have a reasonable expectation of finishing well above 2%.  How much exactly is known as the “risk premium”.

Stock prices have risen as the risk free rate has collapsed to near zero – increasing the premium offered by risk assets.  (The risk premium is calculated by taking the expected return of the risk assets minus the risk free rate,  E(r)[Risk Asset] – R(f) rate.  If E(r) remains constant and R(f) gets smaller the spread will increase).

If the original premium is correct, then prices of the risky asset should rise reducing expected returns on the risky asset to the point where expected returns maintain the same risk premium. 

However, if volatility in stock prices rises, the greater risk suggests that the equity risk premium should rise, and therefore, lowering the risk free rate will not raise equity prices as much as would be expected.  In fact, if the risk free rate is perceived to be heavily manipulated, such as by extensive central bank intervention (QE2, anyone), then it may not be perceived as the true “risk free” rate.

The article suggests that retail stock investors may be catching on to this, since, in spite of the strong equity returns since March 2009, investors have yanked over $100 bn out of equity mutual funds (that has to putting hurt into someone’s management fees … wealth managers be warned).  The article notes, rightly that dividend yields (which reduce the volatility of returns by adding a regular payment that is not subject to market pricing) have collapsed from 5% to 2% over the same time period (that is, since 1950).

I think the writer underestimates the significance of the lowered expectations of returns.  For years, investors were fed a steady diet of the idea that 1) equity premia were too high, 2) that the stock market experienced a geometric growth average of around 10% – at least since 1926, and 3) that over the “long term”, the market goes up.  Thus, what financial “professionals” were selling to retail investors was something like a turbo-charged savings account.  In exchange for “temporary” losses, an investor – really a saver – could earn a high return on their savings.  Wealth building 11% returns were to be expected.

Of course, it hasn’t turned out that way.  Geometric returns since 1926 have fallen, as stocks have moved sideways for 10 years, earning only the dividend yield.  Americans shouldn’t feel too bad – if you invested in Japanese equities anytime since the early 1980s and have held, you have experienced negative returns, money invested in 1989 is still underwater by 70%.

But here is the thing – portfolio theory says that given a specific level of volatility an appropriate risk premium can be determined.  I think that the risk premium is also a factor of expected returns.  11% returns, when compounded over decades, produce very positive financial outcomes.  Lower that amount, to 8% or in my opinion a more realistic 6%, and all of a sudden, dreams of big houses, vacation homes and a boat begin to look less like sure things, and purchasing equities with savings begins to look like a risky way to pay for healthcare and food in retirement – you know, the stuff our parents and grandparents purchase.

Suddenly, the stock market doesn’t look like the best place to put one’s savings.  And so, the retail investor wants to put more money into lower volatility assets, to be sure to have something left with which to purchase necessities.  It may require increasing the amount one saves from earnings dramatically.

The article’s author does suggest a good additional approach – create an asset of your own by starting a business.  As he notes, most of the inputs are inexpensive right now, and with few attractive options to invest your money in portfolio assets, a business may be the best wealth builder yet.

Here is the link.

Has the Stock Market Gotten Riskier? - Investing - Stocks -

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