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Risk in Asset Pricing

Risk in Asset Pricing

February 15, 2023

Are you a good customer? 


Being a creature of habit has served me well, and developing a reputation as a good customer has often meant getting more for less. 


I frequent a local Mediterranean restaurant because the food is healthy, and I'm usually greeted with an extra bread, an upgrade from a small to a medium tabbouleh, a 10% employee discount, or even a branded t-shirt for my 7-year-old daughter. 


Today, a free drink left me pondering the connection between risk and asset pricing with a cogent microeconomical example.


Why do businesses give repeat customers free stuff? And should they? 


A repeat customer doesn't cost a restaurant much less in terms of expenses. The food costs are the same and the demand on labor is the same, so in theory if a repeat customer makes 10 visits the cost to serve this customer is tenfold, and the customer should be charged the one-time price, 10 times over. Therefore, offering a business 10 times the one-time profit.


From that point of view, repeat customers would never be discounted, and yet they frequently are across the board. The question is why? Why would a business sell for less to a repeat customer?


The answer has to do with risk, and provides a great example of how risk costs money, and de-risking is worth money.


A repeat customer helps a business manage risk by offering more certainty. That certainty aids the enterprise in budgeting and forecasting. One could argue that a business might offer a repeat customer a discount simply for removing a little stress and anxiety from its world. One might also argue that the business actually does save on marketing costs by retaining a repeat customer.


But we can go further.


The certainty alone is worth actual dollars. Consider that a business operating with a smaller margin of error requires less liquidity in the form of a smaller operating account (or 'emergency fund'). Money not saved in an operating account to handle uncertainty can then be reinvested, and earn the business a higher return on its capital.


Conversely, the more uncertain a business is about its future cash flows, the more it must stow away in bank accounts yielding almost no interest at all, “just in case". (What a travesty - the bank then lends the depositor's money and risks it anyway, earning a pretty penny for its own shareholders.) Whether you like it or not, capital will flow like water to the ventures which offer the highest returns. The best forecasters get to keep it. 


The key insight is that money held in 'reserve' is not much better than inventory at a grocery store. Food on shelves expires, and the purchasing power of bank deposits erodes with each passing day.


But put those excess bank deposits into higher-yielding investments and a business's balance sheet will age like scotch in a barrel. The variability of 'risky' investments smooths out over longer intervals and what often remains is the malty flavor of higher returns on capital.


A business can earn a higher return on money invested versus saved, can invest more money and save less in the presence of more certainty, and a repeat customer offers a business more certainty. An enterprise is richer in the presence of repeat business, and the smart companies are willing to split that profit with a repeat customer by offering a discount, 'rewards points', or an upgrade to incentivize the behavior.


This is true in the microeconomics of businesses, and extends quite nicely to the world of stocks - an asset which represents less risk/volatility is simply worth more. 


I'm often amazed at how overstated the risk of stocks are in the marketplace - they are far less risky than their reputation would suggest. Alternatively, the risk of owning real estate is understated. The behavior of a diversified stock portfolio over 5-, 10-, and 30-year time periods is well understood.


If you're smart and recognize that the perceived risk of stocks is routinely larger than the actual risk, you can draw the conclusion that stocks are often more valuable than your counterparties believe. If you're shrewd, you can capitalize on opportunities to buy at discounts from sellers who have formed inflated, less-informed risk assessments.


There aren't many free lunches in finance, but they're available to good customers who eat at off-hours, come in on holidays, or buy stocks during market pullbacks.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.

Stock investing includes risks, including fluctuating prices and loss of principal. Past performance is no guarantee of future results.