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swati Bakhda made post

What is risk premium and how does it matter to an investor?

Answer
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Anu Biswas answered.
2 years ago


Successful investment strategies are all about buying into risk premiums. You cannot become a successful investor without taking on risk. Great trades in the world like Tudor Jones buying on Black Friday in 1987 or John Paulson shorting sub-prime in 2006-07 are all trades about risk-premiums. What exactly is a risk premium? When you buy a stock you look at the risk-return trade-off. But there are occasions when the trade-off is crazy but nobody is looking at it. That is what happened when Tudor Jones started buying in October 1987. Over the next few months, he made millions of dollars purely by focusing on the risk premium and taking the trade of his life.
As an investor, you get many opportunities to make decent money and a handful of opportunities to make big money. It is these big opportunities that will really position you as a successful investor and it is all about focusing on the risk premium. That means the returns are likely to be infinitely larger than the risk that you are taking on. Even capturing risk premium can be a dangerous game because the time period is not too certain. For example, John Paulson started shorting sub-prime paper way back in 2006 and 2007. But it was only after the Bear Sterns crisis and the Lehman crisis that he could actually see the money. That is a risk you run when you chase risk premiums. But that is the route to making big money in the stock markets?