Why do some investments yield so little? – 02/21/2023 – Bernardo Guimarães

In general, risky investments have a risk premium: they yield more, on average, than sure-yield bonds.

However, in a column published a month ago, I talked about complicated financial products that had uncertain returns and, on average, lower returns than bonds with very little risk.

Why do risky investments typically have a risk premium? And why do some complicated financial products pay so little?

The story begins with the financing of a venture.

Setting up a bakery, a fintech or any other business requires money and has an uncertain return. The future may bring high profits or losses.

To finance the business, the entrepreneur can take a loan from an investor and pay a predetermined interest rate. That’s a debt contract. The only risk for the investor is that of default.

Alternatively, the entrepreneur can issue a share. As in a debt contract, the money to finance the project comes from an investor. The difference is that, in this case, the return for the investor depends on the success of the enterprise.

The great advantage of this form of financing is that the entrepreneur shares the risk with the investor. The amount paid by the entrepreneur is proportional to the profits.

In general, we prefer to avoid risk. So we buy insurance.

So, to share the risk, the entrepreneur is willing to pay more, on average, to the investor. Likewise, to accept the risk, the investor requires a higher average return.

This is why risky investments that share the risk between entrepreneur and investor have a higher return, a risk premium.

In fact, using sufficiently long data series, we observe that stocks outperform risk-free investments in almost all countries, including Brazil. But because of the risk, over a period of a few decades, stocks may yield less.

In the financial market, there are many ways to share risks. Options, futures contracts, securitized securities and structured products are examples. In principle, this all serves the important economic function of channeling resources to the most productive activities and spreading risk in the most efficient way.

But there are products that do not generate any of that.

Now consider a COE (Certificate of Structured Operations) of those complicated ones, called “autocallable” in the market, whose return will be high if the shares of Netflix, Apple and Google go the same way and will be low otherwise.

This COE is not transferring risks that exist in ventures to you. He is creating a risk. A bid.

Bets have no risk premium.

Lotteries and betting on football results give negative returns: on average, bettors lose. It has to be that way, because whoever organizes the bet needs to make money.

Similarly, whoever issues a financial product that is a bet is taking a risk. Need to earn extra money from it. This means that the return on the product needs to be less than the risk-free product. Empirical research using Brazilian data corroborates this thesis.

Don’t expect magic from your investments. Be it in Campina Grande, be it in New York, be it in the small and peaceful town of Miracema do Norte, risky investments that finance, directly or indirectly, risky ventures yield, on average, a little more than government bonds. The difference is really noticed in longer terms. Bets, however, yield less than risk-free applications.

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