In Short
Compensating Differentials are a fancy way of saying that people are not willing to do horrible jobs unless they are paid more.
Wages vs. Comfort
If we take 2 jobs that require equal skill, on average the total compensation will be the same. Compensation isn’t just cash but includes working conditions. For example: compare a librarian at an elementary school with a librarian at a prison. The working conditions at the prison are most likely more unpleasant (due to the mood) and thus for anyone to be willing to work there they need to be paid more (and they do).
Application to What I Do
This tradeoff between financial returns and comfort also exists in the financial markets. Let’s say we have a really risky bond. The chance of default is very high. Anyone holding that bond suffers great stress. That stress is, in essence, negative compensation as it makes your life worse off. Therefore, to get people to buy the bond it has to offer a large financial return. On the other hand, a bond with no risk just has to offer financial compensation. The total compensation for both bonds are roughly identical. This same trade-off schema exists for stocks and all other financial assets.
As I’m writing these to help my readers, I would be very appreciative of any input in regards to what I should write next. Please contact me if you want me to write about a particular topic. If you would like to submit a post to my blog, please contact me.
If anything that I mentioned above interests you, please consider downloading my free e-book. The book contains my thoughts on investment management and some information that I think everyone should know. You can also download it below.
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Questions for the comments
Did my explanation make sense? Do you agree or disagree with what I said?
