Are Stocks Too Risky Right Now?
- By Matthew Tibble
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- 6 min read
Summary
- The Russia-Ukraine war, rising inflation and the start of central bank tightening cycles leave a troubling outlook for investors.
- Understanding risk premium helps us evaluate the riskiness of stocks in relation to the state of the world.
Macro Implications
- Risk premium may outweigh fundamentals as the dominant component of asset price movement.
- Research shows it is dangerous to leave equities out of a portfolio completely.
Why Risk Matters
The Russia-Ukraine crisis has thrown European markets into chaos. Between the start of the invasion on 22 February and 7 March, the DAX dropped 12.65%. Last week, the FTSE 100 posted its biggest losses since the Covid-19 pandemic as the conflict escalated, falling 6.7%.
The invasion has wiped billions of dollars off equity prices. The outbreak of Covid-19 did the same, so did Brexit, and so undoubtedly will other major events in the future. These Black (or perhaps Grey) Swans are the extreme outcomes of the risk investors take when they hold assets.
But loss of capital can come in all shapes and sizes – not just the extreme and unexpected. For example, it can come from financial mismanagement, poor performance, or long-term market conditions.
Investors tolerate this risk in the hope of greater reward – a yield exceeding the risk-free rate of return. We call that compensation the ‘risk premium’. Without it, we would all be holding ‘riskless’ assets like US Treasury bills. But with it, investors fund novel initiatives at small-cap companies, enter emerging markets, and buy riskier stocks hoping the market will reward them. Yet how exactly does risk get baked into price?
What Is Risk Premium?
To understand risk premium better, we spoke to the Managing Director and Global Head of G10 FX Options Trading at Goldman Sachs Adam Iqbal. In his new book, Foreign Exchange: Practical Asset Pricing and Macroeconomic Theory, Iqbal argues that risk premium is the dominant component of asset price movements – outweighing the role of economic fundamentals.
But the problem is that it is poorly understood at a microeconomic level. A trader might recognize a risk-off day and intuitively know what will rise and fall. And you have asset managers who create risk premium strategies: they find different corners of the market that offer what they call ‘risk premium’ and then implement that strategy systematically. Yet few understand exactly what risk premium is and how it works.
The idea, according to Iqbal, is this:
‘You never enter a bet at its fair actuarial value. You always need a premium or a discount depending on how that bet is going to correlate with your own outcomes, whether it’s a recession or a boom period, whether it’s a period in which you have personal wealth or you don’t and so on.’
The risk premium comes from how we relate the outcome of an event to our own circumstances. In other words, it is not just the objective probability of an event happening that matters but also the subjective size of the impact.
Umbrellas in the Rain
Iqbal suggests an example to better illustrate the point:
‘Say that we’re going to bet on a toss of coin. It’s a fair coin. If it’s heads, you give me an umbrella, and if it’s tails, I’ll give you an umbrella. Sounds like a fair bet, right? You’re happy. I’m happy. It’s perfectly symmetric. We go and do that bet.’
The objective probabilities involved in that bet are simple. It is 50-50. But that perspective takes no account of the external state of the world and the potential impact on personal circumstances.
‘Now, let’s change it slightly. I turn on the radio and the forecaster says that there’s a 50% chance of rain tomorrow and 50% chance of sunshine. And I say, “Okay, well, you are happy to bet umbrellas at 50-50 odds with me. So why don’t we say if it rains tomorrow, which it will with 50% probability, you give me an umbrella, and if it’s sunny tomorrow, I’ll give you an umbrella.”’
As Iqbal humorously puts it, ‘All of a sudden, you’re a lot less happy with that bet.’ And the reason is that although the probability of each outcome is the same, the impact – or the correlation with the state of the world – is different. Nobody wants to be short an umbrella on a rainy day.
Compensating for Risk
For that bet to proceed, you need to introduce compensation – you must sweeten the deal.
‘So I can say, “Okay, if it rains, you give me one umbrella, but if it’s sunny, I’m going to give you two umbrellas.”’
‘And you might now take that bet because you’ll say, “Okay, well, if I’m unlucky and it rains, I’m going to get rained on. But if it’s sunny, I get double the payout. I’ll get two umbrellas and I can use those umbrellas in the future on another rainy day. I might be able to sell one of them or trade one of them for something else.”’
In this example, although the objective probability of rain is 50%, it is trading at two umbrellas to one umbrella. That makes the market implied odds of rain 66%. And another word for that is risk premium. It is when, Iqbal explains, ‘asset prices trade away from their objective probability…and at a premium.’
The Risk Premium for Equities
It is one thing to discuss umbrellas in the rain, but how do we calculate the equity risk premium (ERP)? Economists argue over the right measure, with the capital asset pricing model (CAPM) being a common one. Meanwhile, Professor Aswath Damodaran of the Stern School of Business has a widely followed implied ERP approach.
Damodaran describes the ERP as the ‘receptacle for all our fears’. And in many ways, he is right. Like our bet with the umbrella must encompass our fear of rain, the ERP includes all our uncertainty about the economy, inflation, catastrophic events, government policy, geopolitics and more.
The ERP has averaged about 5% over the past century. But that means nothing to an individual on a particular day trying to make an investment decision. The ERP will fluctuate depending on whether stocks are currently cheap or expensive, their dividend yield, the inflation rate, and whether we are looking at just one stock or a basket.
Counterintuitively, the ERP falls when stock prices rise because their future growth potential shrinks, and vice versa. So when the stock market is suffering, it can rise – after all, people love a bargain.
Balancing Risk During Tough Times
Despite a brief rally, the S&P 500 dipped into correction territory in recent weeks. Other risk markets have followed suit. We are predicting a 45% chance of a recession, up from 18% at the start of 2022. And with the Russia-Ukraine crisis persisting and inflation ramping into overdrive, having faith in the stock market is hard.
Worryingly, Credit Suisse found that equities gave a real return of -10.0% during periods of inflation. Yet research on the risk premium shows leaving equities out of a portfolio completely is dangerous. In the long run, they tend to win out.
We emphasize the benefit of diversification during hard times – across stocks, countries, and asset types, and even into cash. In a recent Deep Dive, we revealed how commodities and collectables have historically offered good returns in inflationary periods. Bonds struggle, though. The same Credit Suisse report found they returned -27.4% during inflationary periods. But they become an important hedge should disinflation return.
And equities can still do well with the right strategy. We explored how the latest research shows they are becoming less sensitive to inflationary news. And if the recent performance of the DAX shocked you, consider European banks instead. We think they will outperform equities as central banks start to tighten.