Correctly priced risk: what is that?

Even simple items have prices that reflect a lot of pressures, including supply and demand, patents and market manipulations. This post will focus on those items whose price has a significant speculative component.

The price of baked goods can go up because it is perceived that the use of corn for bio-fuel will reduce the availability of corn syrup for sweetener. I am looking at more direct effects of speculation than this.

Penny stocks. Precious metals. Oil futures. Lottery tickets. In all of these there are winners and losers; lotteries are unique in that the “game ends” at a specific time.

If we had a church raffle to raise money, we would take some of the ticket proceeds out of the bowl before dividing the rest amongst the winners. The amount taken out makes the gamble “unfair” in that, if one were to buy all the tickets, one would lose that much money.

Horse racing (I am told) is one of the better gambling bets; out of about $2.20 the track takes $0.20 and divides the rest based on the actual betting of the participants.

Stock markets take out commissions. Again, the amount taken is generally small with respect to the overall amount “bet”. But it is taken out.

However stock market issues can have extreme volatility, at least for some issues in some circumstances. The question is, is that risk correctly priced?

I submit that, if it is, by making a large number of bets you cannot get ahead. You will win big some of the time, lose big some of the time, and pay trading commission all of the time.

Profit on the stock market does not come out of the sky. Every winner is financed by one or more losers. And conversely. The exception is stocks that pay dividends.

Put this another way: One could invest in totally secure things, like government bonds (at least we think they are still secure, eh?), and get a guaranteed return that could be above inflation. If investing in speculative stocks yields more than this, then there must be an offsetting possibility of loss which evens out over a large number of trials.

That’s what correctly priced risk is.

I recall when junk bonds involved in leveraged buyouts were all the rage, and made a lot of people a lot of money. Then one issue turned to dust, zero value. One wag commented: when you were getting 19%, you guessed that they were not T-Bills.

So this is the final question: if risk is correctly priced, can you win overall? I submit that you cannot. Insider information, luck, manipulation can alter the outcome. As a fair bet, however, you can’t win if risk is correctly priced. That’s what it means. And you will pay commission.

 

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