In investing, higher risk means that you should expect higher returns – or, if things don’t work out, bigger losses. The more risk you take on, the more money you should make – or lose.
This is true whether you’re deciding between stocks and bonds, or between a penny stock and a blue-chip utility. It’s also true when you’re looking at different markets around the world.
A key building block of the financial concept of risk is the “risk-free rate of return” on an investment. This is usually defined as the return on a U.S. Treasury bill. (Treasuries aren’t really “risk-free,” as we explained here, but they’re the closest thing the financial world has to risk-free.) The yield on a three-month U.S. T-bill right now is 0.26 percent.
A “risk premium” is the minimum amount of excess return, above the risk-free rate, that an investor requires for taking on a certain level of risk. The “equity risk premium” is the extra return (above the risk-free rate) that an investor expects for the risk of investing in stocks, as opposed to risk-free U.S. Treasuries.
Similarly, the “country risk premium” refers to the additional (above the risk-free rate) return that an investor expects as compensation for putting money into a particular country. Investing in higher-risk markets means that investors would require higher returns – since the chances of suffering steep losses are a lot higher than in less-risky countries.
Every investor has his (or her) own sense of risk and of country risk premium levels. To quantify it, investors and analysts look at a country’s sovereign bond yields (and spreads), volatility, political stability, legal infrastructure, inflation, and a range of other macroeconomic and political factors.
Researchers at the University of Navarra, in Spain, recently surveyed investment analysts, company managers and economics professors in more than 70 countries to put together a consensus of different countries’ risk premiums. They found that the average estimated country risk premium ranged from just under 5 percent in a few countries, to a high of 15.3 percent for Venezuela.
Singapore clocked in at 5.9 percent, Malaysia at 6.5 percent, and China at 8.3 percent. The U.S. was at the lower end of the spectrum, at 5.3 percent.
Venezuela richly deserves the title of riskiest country. After years of terrible government and bad policies, Venezuela – which has more oil reserves than any other country on earth – is in the process of falling apart.
It’s suffering from hyperinflation and widespread shortages of basic staples. Its political system is completely broken. Rampant crime makes it one of the most dangerous countries in the world. It’s gotten so bad that the government is having difficulty finding the cash to print more money.
Investing in Venezuela is very risky. The yield on a 10-year Venezuelan government bond is currently 28 percent – about 17 times higher than a U.S. 10-year government bond.
Every market has a unique combination of factors that reflect its country risk premium. Falling commodity prices could affect the Australian economy, a military coup could boost political uncertainty in Thailand and volatile oil prices could cause problems for Russia’s economy. In a market with a high country risk premium, good returns could be wiped out by currency depreciation, or by the government confiscating assets.
How do investors make money in risky markets? By investing when market risk seems very high… and then benefitting as a market becomes less risky (through a political change, or an improvement in the economy, or similar factors). Or, if the feared risks don’t actually amount to anything.
Frequently, perceptions of a country lag reality – that is, investors remember that the situation was bad in a particular market. They may rely on out-dated impressions and information, and aren’t aware that the investing environment has improved. So they assign a higher country risk premium than makes sense given the new reality.
Of course, markets that have low country risk premiums are by no means risk-free. Singapore’s stock market lost 14 percent in 2015 – hardly a low-risk investment. And Hungary, which has an average country risk premium of 8.1 percent, saw its stock market rise 35 percent in 2015 – to make it one of the best-performing markets in the world.
Assessing risk is more of an art than a science. Looking at indicators that reflect the past will tell you what the perception of risk was – but not what it will be, which is what matters more to markets. And high risk isn’t bad… as long as it’s part of a balanced portfolio.