The most common measure for risks in the financial markets is standard deviation, written as the Greek letter (stigma). Standard deviation is a mathematical formula that expresses the average amount of price volatility in a market. Standard deviation does not express the limit of market risk; it simply tells us the “average miss”. How far the market return in any given year was from its historical average annual return.
Markets with the highest risk have generated the greatest long-term returns. Using historic risk numbers for each market and plugging them into a pricing model that also includes the current interest rate on Treasury bills, we can estimate expected future rewards for all markets.
The returns of stocks and bonds vary from period to period. However, the risk of a market tends to be much more consistent and more predictable than its return. Since the risk of a market is fairly constant, we can use that data to forecast an expected reward for talking this extra risk. Stocks have more risk than Treasury bills; therefore, stocks should have a “risk premium” over the return of T-bills. The financial equation used to forecast expected market returns using risk as a factor is called the Capital Asset Pricing Model (CAPM).
I will spare you the details of the CAPM equation and just provide an overview. We know the safest security you can own is a T-bill. The federal government has the power to print money and will pay off all T-bills. That makes the T-bill a “risk-free” investment. The return of T-bills can be forecasted to be 1.0% higher than the inflation rate over the long term. Since there is no investment as safe as a T-bill, you can estimate the return of other investments by adding a risk premium to the T-bill rate. The extra layer of return is directly related to the extra asset risk In the investment and is calculated In the CAPM equation.
Now, I am going to make a change to the CAPM, which might be considered heresy in academia, but you have to take a stand sometime. I do not believe T-bills are a good indicator for the risk free rate. T-bill rates are artificial. They are very close to being directed by the dealings of the Federal Reserve Board. A better risk-free rate is to just use inflation itself. That takes all the biases out.
You may be wondering why the expected returns are higher than the historic returns for bonds and lower than the historic returns for stocks. Bond prices have become more volatile since the 1950s, due to increased volatility in the inflation rate. Since we must get paid more for taking more risk, the projected return of bonds is higher than the previous 50-year average. On the other hand, the return of stocks since 1950 reflects expanding valuations in the form of higher price-to-earning (P/E) ratios. Although the bear market of 2000-2002 has knocked down valuation some, they are still on the high side relative to historic norms. As long as inflation stays low, stock can remain at a higher than average P/E ratio. However, if inflation increases, then I would expect the P/E of the markets and showing how mixing asset classes together actually reduces risk and increases return.