Fear Premium, Not Risk Premium

What is the Fear Premium?

What is the Fear Premium? I’m glad you asked!

Fear and greed. The motivations that dictate investment behavior of the uninitiated. At times, they are palpable. You feel them deeply, viscerally. We all know the feeling of fear or greed.

So much so, that the equity premium (the amount you get above the risk free rate for investing in equities rather than treasuries) is sometimes called the Fear Premium. Fear is what transfers money from the average Joe to those who are patient and understand the psychology of the stock market.

Warren Buffet has great comments about fear:

Be Fearful when others are Greedy and Greedy when others are Fearful

And

Only when the Tide goes out do you discover who has been Swimming Naked

And

Hokey religions and ancient weapons are no match for a good blaster at your side, kid

 

Great stuff! Ok, the last one is from Star Wars, but I’ll tie that in at the end.

How can you use fear to your advantage, and what is the Fear Premium?

First off: can you measure fear in the market?

Fear & Greed Index

Let’s see what we can learn from the Fear and Greed Index. Does it actually measure fear?

At its core, the Fear & Greed Index is an attempt to measure investor sentiment and volatility. There are seven factors scored 0-100 and the average is scored on a speedometer-like scale.

 

measure the fear premium

 

Above, you can see we are in fear. Worse than a month and a year ago… Do you feel it?

Everyone knows a recession is coming.

Fear Premium Measured Over Time

How does this look over time?

 

fear premium over time

 

Now we see why the Fear & Greed Index is useless. See how it massively swings from extreme fear to extreme greed and back again. It is average investor sentiment; a retrospective score of how the stock market is doing.

This is not a shockable rhythm for ACLS purposes. A seizure? It’s not a brain wave or a fever curve, or a measure of respiration. No intervention is required.

The Fear and Greed Index is a statistic looking for a news story.

So, if we can’t measure fear, can we still benefit from it?

The Fear Premium

Let’s talk about the Fear Premium and how you can benefit from it.

I like Fear Premium rather than Risk Premium.

It is said you get stock market-like returns because you take risk. Actually, it is because you can face the fear of risk!

The fear premium demands that you are paid more for your money because there is the risk of loss. While others are nervous about a future event (or nervous that the market is down), you keep your skirt or pants on and stay invested.

Often times, the fear premium is applied to commodities. Sure if there was a hurricane in orange country, you might expect future prices to go up.

But you also see fear premium commonly used with options as well. This is especially true when there is volatility, and speculators need to pay more for hedges to their long equity positions. This fear premium makes hedges cost more.

I see the fear premium as reward for those who understand buy and hold. They buy low cost broadly diversified ETFs when they have money, and sell them when they need money. They understand that volatility is not a risk for the young, and that there are easy ways to mitigate sequence of returns risk.

If you understand that fear goes up and down (see the graph above), then you can just ignore it. Stay on target for the long term.

Fear Premium… Stay on Target

Don’t plan on hokey religions and ancient weapons to save you. Rather…

Fight Fear with Star Wars

“Stay on Target… Stay on Target” meanwhile Darth Vader is coming at you from behind. You know he’s gonna blast you away.

Popular press is panicked. Hot tub tips turn to: sell now before you lose your shirt.

Fear will hit the fan, and you know viscerally Darth Vader will get you (before you bullseye the Womp Rat).

Then Han shows up in the Millennium Falcon.

Ironic… saved by the Millennium Falcon, named after the 1000-year anniversary, the very same namesake as the Millennials.

So, in Star Wars, a crusty ol’ selfish bootlegger shows up just in time to rescue the untrained Jedi and save the day.

Will millennials—the young Jedi’s—heed the warning to stay on target, or get help from a crusty ol’ investing bootlegger and fight the fear away?

 

Think about this now. What will it take for you NOT TO SELL when panic rules the street?

Will you turn off the TV? Good thing millennials already cut the cord. Shut off the stock app on your phone? Delete Instagram? Yes, yes, do what it takes to not hear the fear.

But also think about who is driving your Falcon.  Who is your scruffy-looking nerf-herding hero?

Decide now who you are going to be when the tide goes out… and there is blood in the streets. How are going to behave when you viscerally know the world is ending because you lost half of your investments. Decide now who you are going to listen to and who you are going to read. Do you think they are going to panic and sell low?

Find your mentor now. Then, develop good habits.

Know inside your soul that the market is going to crash and that is a good thing. There is no market risk for young Jedi’s.

Dark days are ahead. Inevitably.

Plan now to Bullseye that Womp Rat and get the girl. Oh wait, she’s your sister. Never mind.

Just don’t sell low.

Remember, you are being paid a premium to take the fear in stride. The fear premium is what makes investing worthwhile. Figure out now, when the sky is not falling, what you are going to do in the future when it is.

 

Main Image from Chuck Jones Gallery is used without permission. But how cool is that painting?

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