"Capitalism cannot work without risk premiums/cost of capital/hurdle rates. It's not capitalism any more because the capital has no decision to make (everything will be funded, no matter how good or dumb)"
I think you and a lot of people have lost perspective and are putting the cart before the horse.
The whole point of capitalism, the only justification, is to benefit society by driving profits to zero.
The stock market is not a machine to produce profits, it is a machine to eliminate opportunities for profits.
Profit is an intermediate step to the basic social purpose of moving resources where they are needed. The collapse of interest rates and profits are evidence of success.
Risk premiums are something else than profits. They're much more intangible, much more "macro".
If you have three companies, two of which will produce $1M (when discounted with interest rates), and the third one has the prospects of producing $1M but will actually produce $0 due to some fatal flaw in the idea (i.e. will lose everything), but you don't know and can't know which one is the loser - how much should each stock be worth? Assume there's no debt.
It's pretty obvious that it should be less than $1M per company. That's what the risk premium is - the difference between discount rates used for a risky project vs the discount rate used for a non risk asset (i.e. interest rates).
No risk premium means everything is discounted as a "sure thing", as if it was a government bond. It's inherently anti-capitalistic because it means that the capital doesn't get to decide what's possible, what's probable, and what's likely.
Also, note that risk premiums have, a priori, nothing to do with aggregate returns. Risk premium is what you'd make if everything went well. But it often doesn't go well. In my example if all three companies traded for $666k and you bought all three you'd end up with the same amount of money at the end (once the loser is known).
I didn't/don't think that's what the phrase means.
If the expected value is $666,666 then wouldn't be the risk premium be the discount you want for the risk of getting zero, compared to an investment that definitely returns $666,666?
I also feel like I read recently about a study showing that investors are empirically (at least to some extent and at least these days) willing to pay more for more "risk", kind of like lottery players.
I'm a little foggy about why, with the low cost of diversification, investors would demand a risk premium greater than zero, at least.
> If the expected value is $666,666 then wouldn't be the risk premium be the discount you want for the risk of getting zero, compared to an investment that definitely returns $666,666?
Risk premium is something that connects future profits to the present, to create an expected value. It is in fact, typically, a yearly rate expressed in percent. Simple example: say the 10 year bond is 2%, you slap 5% risk premium on top of that and you get 7%, with which you discount future profits to the present expected value. Why 5%? Well that's why I'm calling it "intangible". It's risk, it's hard to say what risk is when often you could not have possibly anticipated all the problems. But you know that they're there. All of the recorded history of humanity confirms that trouble is always there.
> I'm a little foggy about why, with the low cost of diversification, investors would demand a risk premium greater than zero, at least.
Well that's up for everyone to decide [what risk premium do they want]. I'd personally stay on the side that assumes that failure, any level, size and scope of failure, is always possible.
Broad diversification was always possible and executed at the institutional scale. It really doesn't change all that much. All that changed is that the "small guy" can have it. In particular it does not mean that risk was somehow banished from the world by Jack Bogle's work.
In your toy example, it's a huge difference. You have a 1/3 chance of losing all your money without it, but a zero chance if you own all three.
With the stock market, it's not clear exactly what diversification gets you because nobody has the future correlation matrix, but it must be worth something. I think millions of people are implicitly assuming the whole market can't go to zero.
As a venture capitalist, I am mostly with you on the big picture idea of how to view "everybody else's interest in capitalism functioning" here. But I will quibble with the term "profit."
I would say "driving rents to zero." There's a well understood notion of earning an accounting profit, and an economic profit, even under perfect competition.
It's "rents" that perfect competition and market "efficiency" can arb away.
High economic rent corresponds to low risk premium. Utilities are a great example, they trade almost like bonds (not quite; there's still risk in them, just look at the famous Californian one).
Also, "high rents = low risk premium" is the whole idea behind Buffett's moats. He correctly anticipated that risk premiums were far too high for businesses with durable competitive advantage (like coca cola), so he kept buying them even at "high prices", i.e. at apparently "dangerously low risk premiums". And then the premiums eroded even further as the companies proved resilient to competition. That's why, I think, he keeps buying Apple stock despite it being priced so dearly.
The problem begins when you assign a ridiculously low risk premium to something that's so obviously risky, like the recent Silicon Valley "tech" startups, which have no moats, no profits, no margins, tons of competition. But the issue goes well beyond Silicon Valley.
> The whole point of capitalism, the only justification, is to benefit society by driving profits to zero.
I actually agree with the sentiment; but I'll quibble because bringing profits to 0 is very easy and we don't need capitalism to do that; cavemen managed a 0-profit society without any difficulties.
The point of capitalism is about creating a concept of property rights then letting everyone simultaneously make decisions that optimise their outcomes given their circumstances. We've noticed over the centuries that, surprisingly, the snags that might reasonably be anticipated turn out not to matter and capitalism works really well for maximising prosperity. Crazy world.
> The collapse of interest rates and profits are evidence of success.
Interest rates aren't low because people are making decisions that they think are sensible in the absolute; they are low because a suite of irrational government policies are undercutting the market and making rational actors do stupid things with money. It beggars belief that a free market would decide that there are nearly no risks in the future. Risks are the highest they've been in the last 30 years.
"It beggars belief that a free market would decide that there are nearly no risks in the future. Risks are the highest they've been in the last 30 years."
Why? If you put your retirement savings in VT, do you think there is a risk of losing your money, outside the end of the world or a temporary decline when you happen to want to withdraw?
I don't think it is fruitful to argue this is true or not, I'm just presenting this as something plausible I think many if not most investors believe these days, explicitly or implicitly.
But if you really have no chance of losing your money in the stock market as a whole, why should it give you extra returns over bonds? Maybe it doesn't?
You tricked me; I didn't reread my original comment and wrote up something irrelevant. Fixed now. If you read it closely you may discover that it said interest rates are too low; nothing to do with stock markets. They are taking their lead from interest rates though so I doubt they are well prices.
The idea that stocks and bonds should give the same return is bad; the risk in stock is measurably higher than in bonds. In stock, legally nothing strange has to happen for an investor to come out with less money than the initial principle. In bonds; someone has to go broke. There is a clear difference in the level of risk involved.
> do you think there is a risk of losing your money, outside the end of the world or a temporary decline when you happen to want to withdraw?
If we handwave away the risk of having less money at the time of selling then at purchase time then yes, I suppose stocks would be riskless. If we assume the risks won't eventuate; anything appears to be riskless. Eating uncooked chicken is perfectly safe if we assume that there aren't any bacteria in it. That handwave is wholly unreasonable.
I think you and a lot of people have lost perspective and are putting the cart before the horse.
The whole point of capitalism, the only justification, is to benefit society by driving profits to zero.
The stock market is not a machine to produce profits, it is a machine to eliminate opportunities for profits.
Profit is an intermediate step to the basic social purpose of moving resources where they are needed. The collapse of interest rates and profits are evidence of success.