You will be able to name the main risk premia and explain the risk you accept in return for each.
Marcus's T-bills pay a modest, predictable return. His world equity ETF has, over long periods, paid more. Why should it? Nobody owes shareholders a higher return. The answer is that investors as a group demand extra return for holding assets that can hurt them in particular ways, and that extra return is called a risk premium. Every holding you own earns one or more of them, and each one comes with a specific way of going wrong. Knowing which premium you're collecting tells you which bad scenario you've signed up for.
Shares have tended to beat cash and government bonds over long periods because owning them means accepting falls that are both deep and long. You saw the scale in lesson 2.2, Drawdown and time under water are the risks you feel: US shares fell by more than half between 2007 and early 2009, and Japan's main index took over three decades to regain its 1989 peak.
The premium is paid to people who hold through that. It isn't paid to people who sell in the middle of it. Marcus's world ETF, STI ETF, bank shares and chip stocks all earn mainly the equity premium, which is why lesson 2.4 found them moving together. The scenario in which this premium fails is a long bear market, and it can fail for a decade or more.
Lending for longer has usually paid more than lending for a few months, because longer bonds lose more when rates rise, as lesson 2.5, Duration is the risk number for bonds, showed. The extra yield is the term premium.
It fails when inflation and interest rates rise faster than expected. In 2022, holders of long-dated government bonds in the US and elsewhere had some of their worst losses in decades. Marcus's SGD bond fund, with its duration of 6.5, earns a term premium. His T-bills earn almost none, which is why their return is low and steady.
The term premium is also hard to measure. It isn't visible on any screen and has to be estimated from models, and estimates have suggested it was close to zero or even negative in some recent years. A premium can be small for long stretches.
Corporate bonds pay more than government bonds of the same maturity because companies can fail to pay. The extra yield, the credit spread, pays for expected defaults plus a premium for bearing the risk that defaults cluster.
They do cluster, which is why the credit premium tends to vanish in recessions. When the economy turns down, defaults rise, spreads widen and corporate bond prices fall at the same time as shares. Singapore retail investors saw this at close range: several offshore marine companies defaulted on SGD bonds during the oil price slump of 2015 to 2017, and the collapse of Hyflux from 2018 hit holders of its perpetual securities and preference shares. Credit risk on single companies is covered in Bonds, T-bills, SSBs and fixed deposits, module 6, Judge credit risk before you lend to a company.
Assets you can't sell quickly at a fair price tend to offer higher expected returns than similar assets you can. Private equity, private credit, direct property and thinly traded small companies all promise an illiquidity premium.
It fails when you need to sell and nobody wants to buy, or when the fund itself stops you selling. After the Brexit vote in June 2016, several UK property funds suspended redemptions, leaving investors unable to get their money out for months. Among Marcus's holdings, his small SGX-listed chip supplier trades thinly enough to carry a little of this premium, and of this risk.
All four premia are rewards expected over long periods. None of them is paid in any particular year, and each can go missing for a long time. That is what makes them premia: if they were reliable, they would be competed away and nobody would be paid for the risk.
This changes how you read your own portfolio. A holding with a high expected return isn't a better holding. It's a holding where you've agreed to take a specific kind of loss in exchange for a specific kind of reward. A product that promises a high return with none of these risks is either taking one it hasn't told you about, or it's mispriced, and the first is far more common.
Marcus went down his holdings one by one: equity premium for the world and STI ETFs, the bank and both chip stocks, term premium for the bond fund, a little illiquidity for the small SGX stock, almost nothing for the T-bills. For his S-REIT he wrote equity and term, because REITs behave like shares but are sensitive to rates. He then wrote, next to each, the scenario in which it would fail. Now do the same with your own holdings.
List each holding in your portfolio, name the main premium it earns and write the scenario in which that premium fails.
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