PUTTING THE RISK BACK IN RISK PREMIUM

This is your wake-up call: Markets are not risk-free

Risk is back!

I’ve been studying markets for a long time. People’s short memories never cease to amaze me. The US stock-market turmoil on Feb. 5 erased all the gains accumulated so far this year. That would be really terrible—were it not the beginning of February.

True, it was the S&P 500’s biggest single points-drop in history. But the S&P 500 index is also higher than it has ever been. And while the index did fall 4%, or 1,175 points, there have been 41 days when the S&P experienced a bigger drop, in percentage terms, since 1951.

The last few years were remarkable because the stock market kept going up and never seemed to fall—it had risen 7,000 points since Donald Trump’s election before markets turned. Investing in the stock market started to seem like a sure bet: put money in and get a steady 10% return each year.

It was especially enticing when Treasury bills offer just 1.48%. The difference between stocks and such risk-free assets is called the risk premium, the reward for taking risk. It is called the risk premium for a reason.

Economist Tyler Cowen speculates that the stock market in the developed world has become the new risk-free asset. There is more wealth than before and a shortage of safe assets like treasuries, so investors see the stocks in the S&P as another low-risk asset. That may be true, but stocks are still risky. They represent a claim on future profits. Unlike bond payments for a rich country who pays its debts, future profits are uncertain and so are stock prices.

The explanations for why this turmoil is happening now—some argue that a booming economy will bring back inflation, interest rates will increase, and this will lower stock prices, while others speculate that the current tax plan was a step too far—may be true.

But the most likely explanation is more simple. The stock market is risky. Some days it drops. Which days those will be are unpredictable. Higher average returns, the 10% instead of 1.3%, is our reward for tolerating these days. This is why as tempting as high steady returns may look, it is never a good idea to put money you’ll need in the near future in the stock market.


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