Equity Investors Aren’t Being Paid for the Risks They Take

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Equity investors are not being adequately compensated for the economic, geopolitical and financial risks they are bearing. The equity risk premium is too small.

To understand this, consider that, back in the day, a “double dog dare” was a kid's first introduction to evaluating risk and reward. The rarely presented double dog dare happens when one kid dares another to do something foolish. Usually, the kid being dared asks for an incentive to complete the challenge.

When assessing a double dog dare, one usually first values the reward. Maybe there are a couple of candy bars or a soda for completing the challenge. Then comes the risk assessment. Does the potential to break an arm or leg exist? Maybe worse, at least in some children's minds, what will the punishment be for being caught? Simply, is the reward enough to compensate for the risks associated with the double dog dare?

Evaluating the risks and rewards of a double dog dare are not that dissimilar to equity investing, as I explain.

Risk-free rates

Investors should expect compensation in the form of capital gains and/or dividends/coupons commensurate with the investment risk. To help evaluate the risk compensation being offered, investors need a risk-free return to base the evaluation.