Risky Business - Show 128

Thursday, June 26, 2014 4,458 views

Why would someone take the risk of bungee jumping? Because to those who take the plunge, the risk is worth the reward of the adrenaline rush. You can’t get the rush from skiing or snowboarding without taking the risk of flying down the mountain. So why do people believe there are returns with no risk? The job of free markets is to set prices so that investors are rewarded for the risks they take.

When an investor purchases a stock, they pay a price that coincides with the risk that provides the expected return. This economic uncertainty includes the probabilities of future events. When an investment's price has fallen by 5%, one could infer that uncertainty has increased by about 5%. Alternatively, when the price has increased by 5%, without knowing the news, one could deduce that uncertainty has decreased by 5%. In other words, prices react to shifts in uncertainty so that expected returns remain essentially the same. This means the price paid should always be considered a fair price.

A trade happens when there is a willing buyer, and a willing seller. Typically, both parties have access to the same information. So who has the upper hand? The likely answer is neither unless they are engaged in insider trading which is obviously illegal. So when news breaks about a company, all the news is worked into the price within minutes. After all, if someone is holding the stock of a drug company that just discovered the cure to a previously incurable disease, why would they sell that stock…unless of course the future gains are worked into the selling price. 



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