Is this investment expensive or not?
Answer that question accurately and you may have a future of above average investment returns coming your way. However, how would you measure that?
Typical investment analysts use one or some of the basic valuation formulas taught in business school: older models include – the Capital Asset Pricing Model (or CAPM) and the Dividend Growth Model; relatively newer valuation tools include Economic Value Added (EVA) .
Many of these models require a baseline or a risk-free rate to use in comparison to risky investments – in other words, analysts like to compare investments like stocks and high yield corporate bonds to what they would get if they invested in “risk-free” 10 year treasury bonds. Let me see if I can share an example that’s easy for the non-finance person to understand.
Let’s assume that you could earn 6% completely risk-free in a government bond (I know with recent talk on American debt issues, this could be quite an assumption, but stick with me ok?:) With that in mind, how much would you have to earn to accept risk in your investments? In other words, are you happy with a risk-free 6%? If not, how much higher would your return have to be for you to accept risk to your principal?
For many people, 6% would be just fine, but for people who want more, there has to be some way to quantify this risk right?
Let’s go to the other end of the spectrum. If the risk in your investment was that there was a 50% chance of losing 100% of your investment, how much return would you demand to take that risk? (This is a super high risk example). Taking both sides, 6% risk free return and a fully at high risk investment, we can see that there must be a way to quantify return vs risk expectations. It may not be a perfect method but it could be helpful.
The Problem Today
Let’s change the above example. If the risk-free rate were around 2.5% and closer to ZERO % for shorter than 10 year time-spans, how would you compare that to risky investments? now you are comparing 0% to risky investments – if there is no decent risk-free alternative, how do we assess risky investments?
The short answer is that we can’t. And that’s our problem – we can’t use a good objective criteria to assess risk so we must find a SUBJECTIVE way of measuring. And that’s what many are doing.
Furthermore, low interest rates also hurt regular savers who would prefer a risk-free option for all of their savings but can not afford to earn 0-2.5% on their money. And they therefore invest in things too risky for them.
This Zero Interest Rate Policy, or “ZIRP,” followed by central banks, including our Federal Reserve Bank is skewing investment valuations, forcing risk-averse savers into more aggressive investments to earn yield and also creating huge potential landmines for pension valuation (something I didn’t cover).
Bottom line – our current rate policy, which has been good for banks and investment houses, has been disastrous in not so obvious ways for the bulk of America.