Economists often discuss the notion of the additional risk associated with higher returns. There is a general agreement that US bonds are the most reliable securities.
These are labeled as risk-free assets because they have the lowest risk of not getting your cash back. In particular, US government has never defaulted on its obligations which make it virtually risk free.
For many countries it is not uncommon to systematically default on their obligations, for example, Argentina does it every 20 years. From this perspective many economists agree that government securities are created equal.
In order to define risk one has to compute the difference between expected and actual returns. This is typically measured by a standard deviation of a stock such as Cache Inc stock. SAS or Stata provides basic commands to calculate the standard deviation from the list of stock closing prices.
It is logical to expect that higher risk will be taken by investors only if they expect higher returns. That is, higher standard deviation of Cache Inc stock indicates that brokers will recommend it only if the price is likely to increase. On the other hand, increase in the standard deviation implies also high potential losses as any MBA tutor would tell you.
However, it is only the expected relationship and not all bubble stocks pay more as was recently indicated by Facebook publicly traded stock. In general, the rate of return will be an upward sloping curve on the graph versus the standard deviation.
If the government security pays 3 per cent and Intel bond 5 per cent then the difference is called risk premium. This is an additional amount encouraging investors to pay more for the purchase of a more risky security.
Over the long run the risk-free interest rate was about 1 per cent and the S&P 500 return was about 7 per cent in the USA. This quite substantial risk premium is called equity premium puzzle because it cannot be explained by standard economic theory.
This level of risk aversion cannot be verified by the micro level data. In words of a famous economist, with this level of risk aversion people will not tolerate the smallest change such as taking a shower.
Of course, people differ in terms of their risk aversion and each should decide individually. Some investors are so excited about high returns that they are ready to buy junk bonds or penny stocks.
However, even an indexed security linked to S & P 500 that can pay much higher return and acceptable risk level. Indexed securities will fail to deliver high payoff only when the all sectors are unprofitable which is relatively unlikely.
These are labeled as risk-free assets because they have the lowest risk of not getting your cash back. In particular, US government has never defaulted on its obligations which make it virtually risk free.
For many countries it is not uncommon to systematically default on their obligations, for example, Argentina does it every 20 years. From this perspective many economists agree that government securities are created equal.
In order to define risk one has to compute the difference between expected and actual returns. This is typically measured by a standard deviation of a stock such as Cache Inc stock. SAS or Stata provides basic commands to calculate the standard deviation from the list of stock closing prices.
It is logical to expect that higher risk will be taken by investors only if they expect higher returns. That is, higher standard deviation of Cache Inc stock indicates that brokers will recommend it only if the price is likely to increase. On the other hand, increase in the standard deviation implies also high potential losses as any MBA tutor would tell you.
However, it is only the expected relationship and not all bubble stocks pay more as was recently indicated by Facebook publicly traded stock. In general, the rate of return will be an upward sloping curve on the graph versus the standard deviation.
If the government security pays 3 per cent and Intel bond 5 per cent then the difference is called risk premium. This is an additional amount encouraging investors to pay more for the purchase of a more risky security.
Over the long run the risk-free interest rate was about 1 per cent and the S&P 500 return was about 7 per cent in the USA. This quite substantial risk premium is called equity premium puzzle because it cannot be explained by standard economic theory.
This level of risk aversion cannot be verified by the micro level data. In words of a famous economist, with this level of risk aversion people will not tolerate the smallest change such as taking a shower.
Of course, people differ in terms of their risk aversion and each should decide individually. Some investors are so excited about high returns that they are ready to buy junk bonds or penny stocks.
However, even an indexed security linked to S & P 500 that can pay much higher return and acceptable risk level. Indexed securities will fail to deliver high payoff only when the all sectors are unprofitable which is relatively unlikely.
About the Author:
Looking to find the best deal on CSWI stock , then visit www.rus-seo.com to find the best advice on Economics PhD Harvard for you.
No comments:
Post a Comment