A Negative Risk Premium Makes Sense

David Dreman’s 1998 book Contrarian Investment Strategies: The Next Generation is a blockbuster.

One of his findings was this: Although you may have been told that the return that you can get from an investment increases with risk, which is often described in terms of volatility, the opposite is true. Contrarian strategies (low Price/Earnings, low Price/Book Value, low Price/Cash Flow and high dividend yield) consistently outperform alternatives at a greatly reduced risk.

I will take this farther. In today’s environment, it makes sense for you to be charged a premium when you buy stocks. You pay extra for the privilege of higher volatility.

The reason is that there are a disproportionate number of people who need growth to support their retirement portfolios.

Historically, stocks have delivered such growth. And only stocks have delivered such growth. An additional return, the risk premium, has compensated for the short-term and intermediate-term risk of losing money in stocks.

Today, we have a deadly combination of factors: the need for growth to support retirement portfolios, the perception that only stocks can supply growth and the perception that stocks will necessarily supply growth because of volatility.

People are willing to pay a premium to achieve long–term growth in today’s environment. Rest assured, they will be charged. They will pay for growth whether as a reality or only as an illusion.

There will be winners. Volatility assures that some investors will do well. After all, many gamblers beat the house. At least, if they do not play too long.

Have fun.

John Walter Russell
September 4, 2005