Valuation series 1: Risk premiums – why are they so important in investment decisions
Any investment decision is based on what the asset delivers in terms of returns and the investor’s expected return from the investment. In most conversations that we have with investors, the expected return is simply looked at as the opportunity cost of capital i.e. the return from the next best option (let’s call it Option B for the lack of a better name) but, what if Option B is not comparable in terms of the risk rating? What if the risk adjusted return of Option B is better than that of the investment being considered? Then one would be making an investment decision based on inefficient/incomplete information and the success or failure of the investment decision would not be based on sound financial principles but on pure luck.
When the markets are doing well and there is a bullish environment, investors are often fooled by the randomness to believe that they know better and can affect the outcomes of businesses unlike their contemporaries (as aptly described by Nassim Nicholas Taleb in Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets). I could go on about this but that would make a good subject for another article.
Coming back to expected return from any investment option, the expectation can be summed up as the risk-free rate and a risk premium to compensate for the risk. Let’s take two investment options that an investor must decide between, these can be described as follows:
O1 – Investment in a pharmaceutical manufacturing plant
O2 – Investment in a rent-able building
The common factor while estimating expected returns from O1 and O2 is the risk-free rate. So, this should be easy to assume, or is it? Which risk-free rate would one use? The risk-free rate to be assumed should be based on the currency one chooses for estimating the cash-flows and not the country in which the investment option is available (or the investment vehicle is incorporated), so if the cash-flows are in US Dollars then the risk-free rate would be the US Government Bond rate. So, the important information missing in the descriptions of the options is the currency of cash-flows. If the currency is BHD then the Bahrain Government Bond rate would work as a proxy for the risk-free rate.
Once we have estimated the correct risk free rate, then we need to focus our energies on the risk premiums. The risk premium of O1 (manufacturing plant) will be very different from the risk premium of (O2) rent-able building. Primarily, because these are different asset classes one is investing in and the underlying is different for both investments. Thus, risk premiums should reflect not only the risk that investors can see in investments but also the price that is put to assume the said risk.
Now do you see the inadequacy of comparing options with differing risks solely on the returns they deliver while ignoring the risk associated with the respective options?
Let us now, look at the factors affecting risk premiums and the determinants of risk premiums:
Risk aversion – while very complex to calculate, it can be looked at in terms of current investment climate in an economy. Where there is greater risk aversion the greater will be the risk premiums.
Current vs. future consumption – in economies driven by consumption, consuming today gives greater satisfaction than saving for the future. In such a case, the risk premiums will be higher than economies with higher savings rate, obviously assuming ceteris paribus.
Economic health – the health and predictability of the overall economy also plays a significant role in the price associated with risk assumption. The better the economic health, the lower the risk premium.
Information flow or the lack thereof – access to information, primarily market intelligence, both about the supply and demand as well as consumer preferences makes investment decisions more accurate and thus, the price associated with risk is lower in economies where there is significant amount of data available to analyze and assess.
Liquidity or the lack thereof – if there are liquidity concerns with an investment option then it would attract a higher risk premium and this needs to be adequately priced while assessing risk premiums.
Policy environment – the government policy plays a significant role in determination of risk premiums, if there are pending resolutions or reforms expected in the target industry then risk premiums would adjust downwards, if there is no clarity or indecision then the risk assumed would rise leading to higher risk premiums.
Irrationality in investment decisions – when investors are not diversified and are allocating a large chunk of their wealth to specific investments, the risk of non-diversification rises and this leads to higher risk premiums for them. While theory expects all investors to act rationally and allocate their wealth in the optimum portfolio across the risk return spectrum, this is hardly the case and there are significant concentration risks that arise from this form of investing.
As an analyst, it is very critical to look at these determinants and their impact in specific situations to arrive at a comprehensive risk premium accounting for all risks arising out of a transaction. At Falak we take our work as financial analysts very seriously, this coupled with our team’s wide geographic experience and regional knowledge helps us assess the true nature of the risk associated with transactions and gives us the edge in making sound investment decisions.