Chasing the elusive 'Risk Premium'

Welcome to the next leg of our 'Risk Premium' journey

Having come so far in the lesson, one would assume that you have understood that the risk premium demanded by equity investors on their investment is forward-looking, as it is based on the expectation of returns. You have also understood that risk premium increases with higher volatility of expected returns.

Hence, we saw our friend Mr Savvy Investor choose an investment option, based not just on expected returns but expected returns adjusted for the risk. So, take a deep breath and think back on what trait Mr Savvy Investor was displaying when he made the requisite calculations.

He was avoiding risk! He was unwilling to take on additional risk unless he was compensated for taking that risk.

Such risk avoiding behaviour is the cornerstone of rational investing. Textbooks state that a rational investor is risk averse, and that rational investors measure reward using expected return and risk calculated as variance.

Risks borne by an equities investor

Time to take a quick look at the broad classes of risks borne by an equity investor:

As you figured out while reading "Taming the risks" , the risk borne by equity investors can be classified as two types - systemic risk, which is market risk and unsystemic risk, which is risk borne specific to a business. We also discovered that unsystemic risk can be reduced by diversifying investments across a basket of stocks representing various businesses. However, systemic risk is something that we have to live with.

Can an investor expect compensation for bearing both market and business risks?

If your answer is yes, you probably are asking for a little too much. Remember that, as an equity investor, you can spread your investments across a basket of stocks to reduce your business risk to zero. In fact, there are extensive studies that show that even a portfolio with eight stocks reduces unsystemic risk to zero. Hence, the only risk that an equity investor can demand a premium for is the systemic or market risk.

Now that we know what type of risk you can demand compensation for, how do we go about measuring it? Simple, the risk premium for systemic risk needs to equal the risk premium for the market as a whole. After all systemic risk exists because of the pervasive influence of the market.

But just the risk premium for the market is not enough

What have we missed? Let's see... Assume that a new government came to power at the Centre and the Sensex went up by 8% in two days...

1. Would you think HLL, Infosys and HFCL all went up by 8% each?
   
   
2. If you think that they all went up by different percentages, then which one do you think went up the most?

We have all seen that every stock posts different gains for the same gain in the Sensex. Stocks like HLL do not rise as fast as the market nor do they drop as fast. Infosys on the other hand posts gains higher than the market. HFCL, we are all well aware, moves sharply higher whenever the market moves higher while falling more sharply than the market in the downswings.

In other words, the influence of the market forces is different on different stocks. Hence, we cannot just settle for the risk premium commanded by the market. We need to measure how the market affects a particular stock.

The 'beta' factor

'Beta' measures the factor of influence of the market on a particular stock. Financial expert William Sharpe worked out a method for doing just this (calculating the beta of a stock). Many of you would have come across the concept of 'capital asset pricing model' or CAPM.

CAPM makes a fundamental assumption that the historic volatility of stock prices will be mimicked in the future too.

Next time, we will unravel how CAPM and beta help us get a fix on this elusive risk premium. Until then, I leave you with a thought to ponder:

Do you think a high beta stock should have a higher risk premium or a lower risk premium?