It's all about Risk Capital

Professor Aswath Damodaran, at NYU’s Stern School of Business, is a leader in understanding corporate valuation. His recent writings on risk capital is very relevant to today’s economic situation, but perhaps a bit more complex than the average reader would prefer. So here’s a quick take on his discussion on this topic.

We’ve seen stock prices fall, bond rates rise (causing their value to drop), and forget about crypto. Professor Damodaran says this is all a function of Risk Capital.

Risk of course is a combination of downside and upside (there’s no risk in an FDIC insured bank account, but there’s a returns tradeoff). Risk Capital is the portion of money invested in the riskiest segments of each market (stocks, bonds, real estate, and I suppose 100% of crypto fits that description). Similarly Safety Capital is the portion in the safest segments in each markets (again, stocks, bonds, and real estate).

These two need to be in balance for a healthy market: when everyone is afraid and seeks safety, the economy will atrophy as businesses stay away from risky ventures. When everyone is giddy, risk capital is too easily available. What’s wrong with that? While risky assets prices will soar, there will be too much growth in the riskiest segments (e.g., inflationary), and at the expense of more stable and necessary lower-risk businesses.

What makes up an investor’s risk profile? Many investors use a portion of their portfolios for riskier ventures because of the higher expected returns. For some, this is the portion they can afford to lose without having to sell their boat. Or, it could be the piece of their capital with the longest time horizon (like an IRA for a younger person). The mix of risk allocation varies over time.

A Macro View

At the big picture level, there are two important factors. First, you can earn a return on guaranteed investments (US Treasury bills and bonds). When the returns are very low, you’re induced to take on more risk. The second is inflation, which reduces nominal return. On the one hand, that provides higher interest rates, so some investors might cut back on risk taking if they can earn enough to cover inflation. Right now, inflation is higher than risk free interest rates though, with lots of uncertain about future inflation.

Here’s the punch line: “real assets gaining when unexpected inflation is positive (actual inflation is higher than expected).” We tend to like real assets around here.

Is the pullback in risk capital temporary (2020) or long-term (2000, 2008)? How might this affect the prospects for land-bank investments? How will the build to rent segment be affected? We have opinions, (hint: we're bullish on land investments), but they're mostly suited for cocktail party conversation. What do you think?