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The Price of Risk

August 26, 2012

We have often said in these Letters that an investment is just and only the purchase of risk and, therefore, like any other purchase that we might make, we ought to know the price of it, that is, we ought to know the “price of risk” (or “risk price”). In our view, then,

“Investment” = “Purchase of Risk”

and it is that equation that we’d like to think about today. Nor are we the first to be animated by that observation of common sense  (for example, James Tobin, “Liquidity Preference as Behaviour Towards Risk”,1958).which suggests that the value or worth of what we prize now might have none in the future or when we try to sell it.

The “risk”, then, is that we might not get all or any of our money back and, if we do, it might not be able to buy the same things (goods and services) then that we can buy now with our money. Nor is money, in any form, whether it be cash, bank deposits, land, property or capital assets and so on, a store of its current value in toto – it has to depreciate (or it could be stolen or confiscated and it is, therefore, fully “depreciated”) when not engaged in the production of goods and services and it might still depreciate when so engaged (“bad” investments). We admit, of course, that some assets might actually appreciate in value even while they are doing nothing but how much of that can we expect to do in the society as a whole and for how long? After all, disinflation is macabre and not even the ancient Romans could survive for long by doing nothing or merely stealing the assets of others who are doing something.

There are a couple of examples of the “price of risk” that are familiar to almost everyone. When we buy a discounted government bond such as a treasury bill, say $95 now to receive $100 “almost certainly” in ninety days time, then the price of risk is the price of the bond ($95) and the risk is that inflation will not exceed 5% during the next three months when we get our money back (from many but obviously not all governments or firms). Another risk, of course, is liquidity risk – we may need to have our money back sooner than we anticipated and, therefore, we need to sell our bond for whatever we can get for it, which might be more or less than what we paid for it.

As another example, when we buy a house, the price of risk is the down payment and the risk to both ourselves and the mortgagor is that we can make our mortgage payments in the future. If we pay cash for the house, then, of course, the risk is all ours and the price of risk is the price of the house which we might hope to sell at a higher price later (discounted by maintenance,  improvements and insurance costs).

Equity investments in the common stocks of companies do not materially differ from either of these examples and equities have a price of risk (which can be thought of as a down payment) that is not necessarily the same as the stock price (the asset that we bought) for reasons that we will explain.

The Price of Risk
The price of risk for an equity 

is the least stock price at which the company is “likeable”.

(Goetze 2009)

We’re happy to take credit for that because nobody has thought of it before or of any way to understand “likeability” in a way that is provably effective for what it’s supposed to do.

There are, of course, thousands of books and articles in economics, finance, marketing, management, societal good, the commons, and so forth, that advise us on what we might like or should like or could like about a company but, in the context of the purchase of risk, the only thing that we must “like” is that we can expect to get our money back (absent a “gift”) and a hopeful return above the rate of inflation including, in many cases, dividends and capital gains. But the only way that can happen is that someone is willing to buy the stock from us at a price that is more in real terms than what we paid for it (even discounted for dividends).

Likeability
We can provably expect to get all of our money back
and a hopeful return above the rate of inflation.
(Goetze 2009)

Neither “volatility based” investing that is implemented by the Capital Assets Pricing Model (CAPM) and Modern Portfolio Theory (MPT) nor “micro-arbitrage” are “likeable” in this sense. Please see our recent Letter, The Wrong Tools Eventually Strip All Nuts, August 2012, for more on that.

Nor, surprisingly, is a discipline of “buy low and sell high” such as might be implemented by buying only stocks with low price to earnings ratios (low PEs) either in aggregate or with respect to their industries. Please see our Letter, Volatility for the Delta Challenged, June 2012, for more on that and a slightly more technical discussion that melds well with what we’re about to say.

What is “likeable”, however (and we have demonstrated this in our Letter, Stock Prices Are The New Pink, June 2012, and numerous Letters thereafter), is a measurable quantity that we have called N* which is loosely defined as the sum of “what a company owns” and, secondly, “the measurable product of its enterprise”.

N* = “What it owns” plus “The measurable product of its enterprise”

What a company owns, of course, is its net plant and equipment and its inventories, and that’s true of financials as well, although one could think about what those are in the context of what the company, such as a bank or insurance company, actually does in order to earn its revenues and profits. We have found that one doesn’t have to think too hard about that because the “slack” is accounted for in “the measurable product of its enterprise” for which mere idle cash on the balance sheet counts for nothing – it needs to be deployed and, therefore, at risk.

“The measurable product of its enterprise” is its accumulated depreciation plus a quantity that is in the same units as the balance sheet and which we have called GW* and which can be accurately described as “the balance sheet worth of the trading connections” in the sense of Coase (Ronald Coase,  “The Nature of the Firm.” 4 Economica (n.s.) 386 (1937)) and loosely described in the following way:

“In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to inform people that one wishes to deal and on what terms, to conduct negotiations leading to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on. These operations are often extremely costly, sufficiently costly at any rate to prevent many transactions that would be carried out in a world in which the pricing system worked without cost.” – Ronald H. Coase 1960, The Problem of Social Cost, Journal of Law and Economics.

Without this, “capital” is just idle, rusting, depreciating and unattractive. However, in order to calculate it, one needs to develop a theory of firm (Goetze 2009) and a theory of the “N/B/W”-Financing Model (Goetze 2009) which solves a basic problem of investment:

The “N/B/W”-Financing Model

If the investors or owners have (N) and the bond holders have (B) and the investors approach the bond holders to strike a new deal with respect to forming or buying a company, or to restructuring the debt of the company that they own, what is the best outcome within the demonstrated societal standards of risk aversion and bargaining practice?

We can show that the answer to that question is exactly the solution to an “N/B/W”-Financing Model and that the solution (developed by quite different methods) is the same as that of “The Bargaining Problem” of Nash (1953) and Rubinstein (1982) which is usually described in terms of economic game theory and measurable preference relations, none of which are “differentiable” or have anything to do with the “statistics” of baskets of numbers purported to be stock prices or returns. Please see our Letter, Stock Prices Are The New Pink, June 2012.

We can further show that the solution of the“N/B/W”-Financing Model is unique and implies a “theory of the firm” that monetizes the real economy of receivables and payables and develops a “hard currency” – which is money – that we can compare with the values (such as stock prices and the price of risk) established in the financial economy in the units of the balance sheet.

All is for nought, of course, if we cannot then calculate the “price of risk” and prove that it has the property of “likeability”. But, we’ve (B)(N) There and Done That, haven’t we.

For more on this, please follow the Tags or Categories attached to this Letter or simply enter Search for additional references to any term that we have used.

Disclaimer

Investing in the bond and stock markets has become a highly regulated and litigious industry but despite that, there remains only one effective rule and that is caveat emptor or “buyer beware”.

Nothing that we say should be construed by any person as advice or a recommendation to buy, sell, hold or avoid the common stock or bonds of any public company at any time for any purpose. That is the law and we fully support and respect that law and regulation in every jurisdiction without exception and without qualification to the best of our knowledge and ability.

We can only tell you what we do and why we do it or have done it and we know nothing at all about the future or the future of stock prices of any company nor why they are what they are, now.

The author retains all copyrights to his works in this blog and on this website. The Perpetual Bond®™ is a registered trademark and patented technology of The RiskWerk Company and RiskWerk Limited (“Company”) . The Canada Pension Bond®™ and The Medina Bond®™ are registered trademarks or trademarks of the Company as are the words and phrases “Alpha-smart”, “100% Capital Safety”, “100% Liquidity”,  ”price of risk”, “risk price”, and the symbols “(B)”, “(N)” and N*.

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