[Starting next week, the Rule Maker column will run weekly in this space, on Wednesdays. Stop by for more thoughts and further debate from the Maker team!]
Ask 10 people in your workplace to define the word "risk" and I'm willing to bet that most of them will say something like "take a chance." I'll also bet that most of them will consider risk to be bad, and something to avoid. Risk is defined as the quantifiable likelihood of loss or less than expected returns. The key word there is "quantifiable." You can know how likely it is that you'll lose out if you assume a risk.
Let me give you an example. Many people drink coffee each day. They go to Starbucks and pony up $3.50 for a latte terra grande mocha frappa zappa denim chino. They are taking a risk. There is a chance that the coffee will be sub-par and that the enjoyment they get will not be equal to or greater than the money they paid for the coffee. Or, perhaps the coffee will be so hot that they'll burn their tongue and not be able to taste anything for a week in that one annoying spot. Believe it or not, it's possible to figure out what the chances of this happening are. You could survey every single person who drinks a coffee and find out how many "lost" on the deal. This would give you an idea of what type of risk you're taking each time you belly up to the barrista.
Yes, it's a silly example. But it illustrates that in most everything we do in our lives, risk is present, and it can almost always be measured. The same is true for investments of all shapes and sizes. Go back to those 10 people and ask them which is a "riskier" investment, a five-year CD or an Aggressive Growth stock mutual fund. I'm hoping (praying actually) that they'll know that the mutual fund is riskier than the CD. The real question that I hope someone out there is asking is "Why?" Why is the stock fund riskier than the CD? The answer lies in the concept of "expected return."
Whether you know it or not, all classes of investment have an expected rate of return, expressed as a percentage. So, how much should you expect when you invest your money? 5%? 10%? 50%? Because risk is a relative thing, where one investment is riskier than another, you need a baseline or benchmark level of risk that everyone is willing to agree upon.
In the United States, and around the world, U.S. Treasury securities (bills/bonds) are generally considered "risk-free." They are guaranteed by the full faith and credit of the United States of America and as far as risk goes, that's about as good as it gets for most people. So, our benchmark is a U.S. Treasury, specifically the three-month Treasury bill. Whatever the three-month T-bill pays, at any point in time, is widely considered the risk-free rate (RFR). All other expected returns are measured off of this RFR. Any investment you make, by definition, is riskier than the three-month T-bill.
If you're investing in anything other than the three-month T-bill, you MUST expect a higher return on your money, otherwise it wouldn't make sense to take the risk. The amount of extra return, above and beyond the RFR, is called a risk premium. The size of the risk premium depends, of course, on how risky the investment is. For example, the three-month T-bill currently yields 2.09%. A three-month CD is yielding about 2.20%. Not a huge difference, but it illustrates the difference between two fairly similar investment vehicles over the same period of time. The CD, which is likely backed by FDIC insurance, is only slightly more risky than the Treasury bill, and you need to expect a slightly higher return for the additional risk you're taking.
Now, without getting too complicated, one of the factors in determining expected return is time horizon. How long will my money be tied up? The longer your money is tied up, the more return you need to make. Example: The ten-year U.S. Treasury bond is yielding 4.59%, 2.5% higher than the three-month Treasury bill. You are being compensated for tying up your money for a longer period of time.
When you compare investments that span different time horizons, you have to compare apples to apples. If the ten-year U.S. Treasury is paying me 4.59% per year, a ten-year corporate bond needs to have a higher yield to justify me taking the risk of buying a company's bonds. After all, I can buy the government bond and be virtually guaranteed of my 4.59%. The safest ten-year corporate bonds currently yield 5.12%. You can obviously see that you're being compensated for investing in a riskier security, relatively speaking. The risk premium is 0.53% annually.
Lesson over, back to Rule Maker
So, what does this have to do with Rule Maker? Well, nothing specific to Rule Maker, but EVERYTHING specific to valuing stocks. Interest rates (of return), if it isn't already apparent, are key drivers for determining what you should expect from equities. As equity investors we always need to compare what we think our future return might be to what types of returns we can achieve with less-risky securities. Whether you like it or not, this is how portfolios are managed. If a stock's price is so high relative to its value that my ten-year expected return is only 4%, I'm moving my money to the ten-year bond, right?
Next Wednesday, I'll be talking about a basic valuation model for you to think about when trying to figure out what your stocks are worth. One of the factors in this valuation model is interest rates on less-risky investments. For those of you who are curious, I'll lay out the equation now and talk about it next week:
P = EPS * (8.5 + (2*G)) * (4.4 / AAA Bond yield) where
P = Price
EPS = Next year's estimated earnings
G = five-year estimated earnings growth rate
AAA = prevailing yield on AAA corporate bonds
This isn't my brainchild -- it's Benjamin Graham's simplified valuation equation for growth companies. It's also not a magic bullet, not a solution to all our problems, so get that thought out of your head right now. We'll talk more about the equation on Wednesday.
Have a good weekend!