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Individual vs. Market Influence on Risk Premium
Two financial advisors are debating how the compensation for holding a risky asset is determined. Advisor A argues, 'The premium is personal. If I become more cautious, I will demand and receive a higher return for the same stock, and that becomes its new premium.' Advisor B counters, 'That's not how it works. The premium is set by the collective judgment of all market participants about the asset's uncertainty, not by your individual feelings.' Analyze the two arguments. Which advisor's reasoning is more consistent with the principles of how risk premiums are determined in financial markets? Justify your answer by explaining the roles of both individual preferences and the overall market.
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An individual investor, who is one of many thousands holding a particular stock, suddenly becomes much more cautious and decides they are no longer willing to accept the same level of investment uncertainty. Based on the principles that determine an asset's compensation for risk, what is the most likely effect of this single investor's change in personal attitude on the stock's overall market risk premium?
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