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Most people are counting on their pension being there when they eventually need it — and that’s why experts managing pension funds need to understand what could potentially happen if they invest in different types of assets.

The importance of being able to accurately estimate such risk is something that can’t be understated, says Dr. Miguel Palacios, PhD, of the  at the ��ݮ����Ƶ����. “Firms decide where to allocate capital, and investors where to invest, based on the expected returns and risks associated with different types of projects,” he says. “Understanding the relationship between risk and return is thus crucial for both corporations and investors.”

As an assistant professor of finance who has been interviewed by the New York Times and the Wall Street Journal, Palacios is the co-author of a study  in the Journal of Financial Economics.The study is the first to document systematic and significant differences in the average returns between firms based on how large their employee payroll is relative to sales, he says.

Payroll as a source of risk

The study examined a previously overlooked factor driving the riskiness and expected returns of firms in the global economy: “labour leverage.”

Leverage is typically defined as the ratio of a company’s loan capital, or debt, to the value of its common stock, or equity. The idea behind labour leverage is that a firm’s wage payments to its employees induce the same effect as debt on the risk faced by shareholders, says Palacios.

“To grasp the magnitudes involved, a trading strategy focused on buying shares from companies in the top 20 per cent — ranked by payroll relative to sales — delivers returns roughly five per cent per year higher than one focusing on the bottom 20 per cent,” he says. “After only 15 years, the first trading strategy will be worth twice as much as the second one.”

Beyond identifying this relationship, the study digs deep on answering why such a difference in returns exists. It attributes the effect to labour leverage, says Palacios.

The implication is that a significant part of those higher returns are compensation for risk, he says. “All investors want higher returns, but getting them by facing a much higher risk might not be that desirable,” he says.

Students of finance learn quickly that leverage induces risk, and the study finds large wage bills create the same effect, says Palacios. As students also learn, higher risk tends to earn higher returns, and that’s exactly what the study found, he says.

Understanding risk seen as vital

“The result is relevant for any investor, but especially so for fund managers who are responsible for investing large amounts of money on others’ behalf,” says Palacios. “They want to understand sources of risk, and the relationship between risk and return.”

The study is also relevant for “managers in finance positions, for whom the appropriate cost of capital and how much debt their firm should take is a first-order question,” he says. “The paper implies firms whose wage bills are large relative to sales tend to have higher opportunity costs (the loss of potential gain from other alternatives when one alternative is chosen) and a lower capacity to carry debt.”

Besides Palacios, the study was co-authored by Dr. Andres Donangelo, PhD, assistant professor of finance at the University of Texas at Austin; Dr. Francois Gourio, PhD, senior economist and research adviser at the Federal Reserve Bank of Chicago; and Dr. Matthias Kehrig, PhD, assistant professor of economics at Duke University.

Palacios was also recently interviewed for  regarding income-sharing agreements as a method of student finance.