Intuition about hazards: Is this an investment tool?

Last Modified: Saturday, November 30, 2013 at 4:58 p.m.

Every day, people take risks.

Many of my readers commute to work on busy interstate highways that have frequent serious accidents -- but they still do it.

Why? While they don't have a quantitative measure of the risk of a serious accident, they must have at least an intuitive feeling that the risk is very low. If they believed otherwise, rational commuters would alter their route or look for a new employment opportunity.

This type of intuitive risk control is adequate for commuters, but is it adequate for investors? My answer is "no." While it is difficult for investors to measure the risk in an investment with 100 percent accuracy so they can decide if the return they might reap is worth taking that risk, there are ways available to the typical investor to do better than intuition.

Before getting into the "weeds" lets understand why this is important. The only way investors can have consistent investing success is to be paid returns commensurate with the risks they take. If investors don't achieve that, they will see poorer returns and likely more frequent large losses.

To better understand why, let's consider a simple "investment." The stock market will be represented by a normal deck of cards. The investment is $100 that a card drawn at random will be a spade. If it's not, the investment is lost. If it is, the investor receives a return. Since a spade will be drawn about 25 percent the time, the investor will get a return about 25 percent of the time.

If the return is his investment plus $325 then his long-term results will be quite favorable because he's being paid more than enough to compensate for risking his $100.

If the return is his investment plus $275, he will eventually go broke. He isn't being paid enough to compensate for his risk.

Thus, a key issue in investing is: What's the proper return or "risk premium" that an investor should receive for investing in a security, like a stock, that's not risk-free like a Treasury bill? No rational investor would invest in a stock unless they expected its return to be more than a risk-free investment.

The simplest way to price a stock's risk is to do it relative to the risk in the company's bonds. Since bonds are safer than stocks, the return on a company's stock should be higher than on its bonds. For example, recently, Oracle's medium term bonds were returning about 2.25 percent. The risk premium for stock over bonds is typically in the 3 to 6 percentage point range. Thus, to invest in Oracle's stock should require a minimum of a 5.25 percent to 8.25 percent expected longer-term average annual return.

Sophisticated investors have another way. It's understood that stock options contain significant information about a stock's risk. This information can be used to provide a basis to infer the required risk premium for the stock.

To do this, we conceptually use a put option (allows the buyer to sell stock at a fixed price for a fixed period) to create a closely related "risk-free" investment. Since we do this only conceptually the option doesn't have to actually exist; we only require the ability to approximately price it. This can be done, for example, at

We imagine that we have purchased the stock and simultaneously bought a put option at the purchase price. We then use this imagined risk-free investment as a guide to the required return for the stock.

Using Oracle stock's recent price of $35, an estimated January 2019, $35 put option price of $7.25 and the recent annual risk-free interest-rate for this period of 1.4 percent, yields that for this investment's return to exceed the risk-free rate, Oracle stock's price has to be at least $45.30 by January 2019. This is calculated by adding the options price to the stocks price and multiplying by 1.014, five times.

This yields a required minimum average annualized return of at least 5.3 percent.

For more follow me on Twitter @logicalinvestor.

Past performance is not indicative of future results. The data and performance information is for informational purposes only is not intended as a solicitation. Send comments and questions to Robert Stepleman, Business News, Herald-Tribune, 1741 Main St., Sarasota, FL 34236, or rsstepl@tampabay Follow him on Twitter @logicalinvestor.

This story appeared in print on page D12


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