Newspaper article Sarasota Herald Tribune

Are You Getting Enough for Risk?

Newspaper article Sarasota Herald Tribune

Are You Getting Enough for Risk?

Article excerpt

THE RATIONAL INVESTOR

Most investors realize there is a correlation between risk and return. Yet the statement "higher risk brings higher return," while true as a generalization, is far from perfect in practice. What is true is that sometimes higher risk leads to higher return. This means that investors need some way to calculate if the return they hope to receive is worth the risk they are definitely taking.

Consider that investments with the most certain returns, such as CDs, pay annual returns of 1.25 percent or less but investors can be sure that by maturity they will receive their principal and interest.

It's clear that low risk is paired with low return in this case.

Corporate bonds rated "AAA" pay higher interest rates than their U.S. Treasury counterparts because even with AAA-rated bonds there is a very small uncertainty about interest payments and the return of principal. But is the difference enough to make up for the extra risk?

High-quality large-capitalization stocks that pay dividends have, over long periods, have had a tendency for their returns to lag small-capitalization stocks that don't. Again, is the difference enough to make up for the extra risk, for example, of bankruptcy?

Thus, the critical question is: What's the proper return an investor should receive for investing in a security that has risk? We restrict the discussion to stocks.

One way to calculate the required stock return is to look at the return on that company's bonds or a very similar company's bonds. Since bonds are safer than stocks, the return on a company's stock should be higher than on its bonds. Recently, Oracle's medium-term bonds maturing in about five years returned about 2.5 percent. The extra return for a stock over a bond is typically 3 to 6 percentage points. Thus, to invest in Oracle's stock, the minimum expected annualized return should be 5.5 to 8.5 percent.

Stock options contain significant information about a stock's risk. …

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