Apparent Risk vs. Actual Risk

I’m currently working my way through William Bernstein’s Four Pillars of Investing. The point he hammers home in the first chapter is that the market rewards risk by providing additional return on more risky investments. This risk/reward  (or risk/return) relationship is one that’s discussed frequently in the finance field.

However, as far as I can tell, the market rewards apparent risk rather than actual risk.

What do I mean by apparent risk?

An example: One year ago, the stock market didn’t look or feel very risky to investors. Today, however, millions of people have decided that the market isn’t safe right now. It too risky.

I’d say that this is an example of apparent risk rather than real risk. The market is no riskier today than it was a year ago. When we invest, it’s the same companies we’re investing in (minus a few I suppose!). Things just feel riskier because we’ve all been reminded of the unpleasant fact that bear markets are an unavoidable part of investing in stocks.

From an economic perspective, it seems to make sense.

From Econ 101, we know that when demand for something increases, the price for it goes up (assuming supply stays constant). We also know that when the price of an investment goes up, the return offered by the investment goes down. (This is just simple math. For example, if a bond is paying $600 of interest per year, you’d earn a greater return if you paid $10,000 for the bond than you would if you paid $12,000 for the bond.)

And common sense would seem to indicate that how risky an investment looks is going to be more important than how risky it really is when it comes to influencing demand for the investment. Therefore, greater apparent risk leads to lower demand (and thus lower prices), which leads to greater return.

So how can we take advantage of this?

Ignore the noise: Just because people are saying the market is risky right now doesn’t mean it is. Stock prices have been driven down due to a decrease in demand. Might as well take advantage.