Business Times - 15 Jul 2006
Profiting from risk aversion It is during periods when most stock investors are reluctant to commit, when the equity risk premium is at a high, that one will make the most money
By TEH HOOI LING
SENIOR CORRESPONDENT
UP UNTIL May, everything was hunky-dory. Markets around the world were hitting multi-year highs with many experts predicting a continued bullish outlook.
Then, there was a sharp correction in commodity prices, which spilled over to the stock markets. And suddenly, everybody's selling. The reason: investors' risk aversion has increased.
What caused investors to wake up one morning suddenly more risk-averse than the day before?
To begin with, everyone has a different degree of risk aversion. This is determined partly by one's personality and the circumstances one is in.
Some people are naturally kiasu and kiasi. They are less adventurous, and tend to stay away from activities like sky-diving and bungee-jumping. They are also likely to opt for the stability of a secure job than become an entrepreneur. And studies have found women to be slightly more risk-averse than men.
Meanwhile, circumstances are also a factor in forming people's attitudes towards risk. Those with more wealth are more willing to take risks.
Those who are faced with a certainty of loss are more likely to take a gamble. So to be more accurate, the general trait of humans is loss aversion rather than risk aversion.
Recently, it has been shown that attitudes towards risk can be affected by the prospect of being liquidity-constrained and by the presence of additional uninsurable risks.
Thus, individuals facing high labour income risk - which is normally uninsurable - will be more risk-averse and thus avoid exposure to portfolio risk by holding fewer risky assets, or none.
The insecurity of jobs has been one of the main features of the new economy. This, I think, is one of the reasons why the retail participation of the local stock market in the last five years has been scant.
It is also why the equity risk premium for the domestic market has stayed persistently higher than historical levels since 2000.
Stock price link
Stock prices move as corporate earnings prospects change. But they also move as investors change their aversion to risk.
Aversion to risk gives rise to a risk premium, which consists of an expected extra return that investors require to be compensated for the risk of holding stocks.This risk premium, added to the cost of cash, will be used to discount expected future cash flow of a company. The higher the risk premium, or cost of cash, the lower the present value of the company's expected cash flow and hence its value or stock price.
Given that individuals have varying degrees of risk aversion, it is arguable that the risk premium they require for holding stocks also differs.
For example, someone who has intimate knowledge of a company or industry may have a different perception of risk compared with someone who knows only half the story, with even that from hearsay.
Generally, knowledge is inversely related to risk aversion. For example, the lower valuations of similar-sized China companies listed here vis-a-vis those in Hong Kong could be due to, among other things, investors' higher risk aversion as a result of their lack of familiarity with the China market.
Control is another factor. For example, a company may be willing to buy a distressed outfit because it knows it can take control of it and turn it around.
It may be a different story for small investors. It has been noted that one of the advantages of big investors like Warren Buffett is that they can buy enough shares to exert control in a company and implement change.
But it is the aggregate of market participants' attitudes towards risk that will determine the prices of assets. And it is the macro factors, and the market's decision to focus on these factors, that will move the market's level of risk aversion and as a result asset prices.
A poorer outlook for the economy may raise risk aversion and thus equity risk premium, because investors react to the increased likelihood of lower-wealth situations by reducing their willingness to bear risks.
In fact, empirically, it has been established that equity risk premium rises during business contractions and falls during more prosperous periods.
It has also been strongly established that equity risk premium varies inversely with nominal interest rates.
Studies in the West suggest that a one per cent decrease in nominal interest rates (usually during economic contraction) implies about 35-50 basis points increase in market risk premium.
My estimation of Singapore's equity risk premium in the last 19 years showed that a one per cent decrease in nominal interest rates resulted in an 87 basis point increase in risk premium.
But it is during periods when most are risk averse, when the equity risk premium is at a high level, that one will make the most money.
As mentioned, the market's aggregate risk aversion does not stay constant over time. Things will change, the uncertainty weighing over the market will dissipate, improvement will come, confidence will rise and risk aversion will subside.
Investors who dare to buy during the height of uncertainty will be handsomely compensated. They are being compensated for taking 'risks' and for providing the liquidity in the market when there was almost none.
Deducting one-year interbank rates from the earnings yield (inverse of price-earnings ratio) of Straits Times Index stocks as a proxy for equity risk premium, an investor who bought STI stocks every time the risk premium nears 4 per cent and sold when it fell to below one per cent would have grown his or her $1,000 in 1987 to $16,400 today.
Someone who bought the STI in 1987 and held on till today would grow his or her $1,000 to only $3,000.
Currently, the market risk premium based on the above calculation method is near 6 per cent.
Implied equity premiumsUsing the discounted cash flow model, we can also derive the implied equity premiums of the various markets if we have their price levels, their dividend yield, and also an assumption of their growth.
If we assume that dividends payout will grow at a constant x per cent to eternity, the discount rate is simply the dividend yield of the market plus that dividend growth rate. And the equity premium is that discount rate minus the risk-free rate.
Based on a conservative 3 per cent dividend growth rate till eternity, among the markets I looked at, Taiwan has the highest equity premium, followed by the Nikkei, the Kuala Lumpur Composite Index and Singapore. Higher risk premium usually translates into higher returns.
But if you think that certain markets can chalk up higher dividend growth than 3 per cent, say 5 per cent in the next five years, followed by 3 per cent subsequently, then their equity risk premiums are also higher (see table).
For markets like Bombay and Jakarta, the equity premiums are negative. This means that investors are willing to lose money for an exposure to equity. Unless dividend growth is substantially higher, it doesn't look like a wise decision buying these markets at current levels.
Previous articles of this column can be found in volumes I and II of the book
Show Me the Money, available at major bookstores
The writer is a CFA charterholder. Her e-mail: hooiling@sph.com.sg
Copyright © 2005 Singapore Press Holdings Ltd. All rights reserved.
