When you buy a stock, one of the reasons you have the opportunity for profit is precisely because you are willing to take the risk that your investment goes to zero. If you are trying to invest for a ‘sure-thing or nearly guaranteed returns, then those types of investments are available to you. One instrument that is often used as a proxy for the risk-free rate of return is the 10-yr treasury bond. This risk-free rate is significant because it is a necessary input to calculate a fundamental metric in the world of investing, the risk-adjusted return, or alpha as it is also known. This effectively measures how much you are getting compensated per unit of risk. The pursuit of alpha is getting the highest possible return while taking the least possible amount of risk to get it.

External exogenous risks are one of the main types of risks a stock faces. Let’s take us back in time to history when the Dutch East India Company was the only publicly traded stock around to analyze what kind of risks a stock faces. So, since the company’s business primarily involved sea-faring expeditions to far-flung regions of the world, the news that a terrible storm had adversely affected travel conditions might increase the chance that there will be a higher than average proportion of unsuccessful voyages.

Therefore, news about adverse weather in relevant geographies, even in 1602, would likely have harmed the most popular shares of the day. Of course, that news would take much longer to travel before modern communications. To this day, an unforeseen hurricane can affect asset prices just as it would have back then. For example, when hurricanes hit the Southeastern United States, they often cause elevated oil prices. The bulk of refinery capacity in these areas can be shut down by inclement weather. These types of external risks are different from the more idiosyncratic risks associated with each stock or company, known as endogenous risks.

Risks that are specific to each company are often called endogenous risks. Operational risks arising from dysfunction in an organization or its mechanical processes would be an example of endogenous risk. One critical endogenous risk that is always hanging over any management team is how it chooses to invest its excess profits relative to its peers. When you own a stock, a company’s management is one of the most essential elements of endogenous risk you can pay attention to. If a company has a management team that lacks integrity or has a poor track record in allocating capital, then this is a significant risk to shareholders.

Often, management teams will create additional incentives for shareholders to purchase their stock by either buying back shares, which thus increases the earnings per share for the remaining shares (and therefore the value of the company’s equity). One important thing to remember about stocks is that actions that reduce the share count and thus increase your proportional claim to the company’s residual earnings tend to increase the value of the shares.

On the other hand, dilutive actions tend to reduce the value of the stock by making your claim a lower proportion of the claims outstanding. These actions involve selling additional shares or increasing the float. In other words, when the company reduces shares, it means your claim is worth more, and when they increase them, your claim is worth relatively less.

So, when companies buy back shares, this immediately increases the value of your stock because it is now more scarce. The company has not done anything to improve its economic prospects but has still boosted its price. This leads some critics to be wary of gains from share buybacks instead of genuine increases in growth expectations.

Similarly, when air travel was pretty much forbidden by decree, many airlines would not have survived the lost revenue without raising money by offering more equity. These dilutive actions tend to reduce share prices. Many companies undertook dilutive action during the period following the COVID-19 crisis.

Some investors have worried that share buybacks and dividends have risen in importance at the expense of the accretive CAPEX that companies must continually make to maintain their growth and competitive edge. The dividend versus buyback debate is prominent on Wall Street right now, with esteemed thinkers on both sides.