Today, we're going to talk about one of the most basic concepts of investing—risk.
There's overwhelming evidence that when it comes to a large part of their net worth, like their retirement savings, investors are risk-averse. What that means is they will demand a premium for holding risky assets.
If the 10-year Treasury is yielding 4.5%—which is about what it is today—investors will demand an expected return greater than that to induce them to bear risk.
Well, it's easy to talk about risk, but what exactly do we mean?
Academics tend to use mathematical definitions of risk, like the standard deviation of returns. But that may not be relevant for real-world investors. Risk, to them, is what they perceive to be risk.
Let me give you an example of how that perception may change over time and, in turn, influence the level of the market.
Market Performance Over Time
Let's start with the period from January 1, 2000, through December 31, 2013.
If you look at this graph of the S&P 500, you can see that if you bought your portfolio on January 1, 2000, within a couple of years, you'd have lost half your money.
Ouch. That's real risk.
If you were willing to hang on, it would take about five years to recover, but you'd finally get back to where you started. Unfortunately, you'd only stay there for a short period before once again losing more than half your money.
Ouch. Ouch.
You wouldn't get back to your original level until 2013.
People who lived through that would have a very wrenching perception of risk, which would affect the premium they demand for holding risky assets.
Now, let's look at a more recent period—from January 1, 2009, through December 31, 2024.
In this graph, you can see that although there were a couple of downturns, they were short and immediately followed by greater returns. Over that 15-year period, the market was essentially up, up, and away.
For every $1 invested at the beginning, you would have about $9 today.
If we break it down year by year, you can see that every year from 2009 to 2024 was positive, often very positive. The only exceptions were 2018 and 2022, but both were preceded and followed by large positive returns.
For every $1 invested in 2009, by 2024, you would have about $8.70.
That doesn’t feel like much risk.
If you believe the market is always going up and that any rare downturn will be followed by an even bigger positive return, you wouldn’t demand much of a risk premium.
Why Risk Perception Matters for Market Valuation
Now, here's why all of this is important for understanding market levels.
Let me bring up a spreadsheet where we calculate this. I’m not going to go through all the details, as we covered this in an earlier Reflections on Investing episode on the Cornell-Damodaran approach to estimating the equity risk premium.
Instead, I want to show you how important the perception of risk is when pricing stocks in the market.
If you look at the spreadsheet on the screen, you'll see a key figure: the equity risk premium. Right now, it’s 3.56%—an estimate of how much more than the 10-year Treasury rate investors require to hold the market portfolio.
With that 3.56% risk premium, we calculate a market level of 6,270—almost exactly where the market is today.
But now, let's see how sensitive market valuation is to changes in the risk premium.
Over the last 25 years, a more normal risk premium has been about 5%.
If we enter 5% instead of 3.56%, look what happens: the intrinsic valuation of the market drops from 6,270 to 4,297.
Oh gosh. That’s a risk I wouldn’t want to take.
On the other hand, if the risk premium were to continue declining—say, to 3%—the market could rise to 7,150.
The Takeaway: Risk Perception Drives the Market
I think you can see how critical the perception of risk is in determining market levels.
If you believe risk premiums will continue to decline because investors remain confident, that’s a reason to buy the market.
But if you believe risk premiums will revert to historical levels, then it’s a very dangerous time to be holding stocks.
Here at the Cornell Capital Group, we like to say:
"The biggest risk to the market is the perception of risk itself."
This has been Reflections on Investing with the Cornell Capital Group.
Thanks for joining us!