I am calculating the Net Present Value (NPV) for my investments. I used a higher discount rate for the more risky investments. However, the "Common pitfalls" section of the Net present value article on Wikipedia says this:
- Another common pitfall is to adjust for risk by adding a premium to the discount rate. Whilst a bank might charge a higher rate of interest for a risky project, that does not mean that this is a valid approach to adjusting a net present value for risk, although it can be a reasonable approximation in some specific cases. One reason such an approach may not work well can be seen from the following: if some risk is incurred resulting in some losses, then a discount rate in the NPV will reduce the effect of such losses below their true financial cost. A rigorous approach to risk requires identifying and valuing risks explicitly, e.g., by actuarial or Monte Carlo techniques, and explicitly calculating the cost of financing any losses incurred.
Why can't I use a higher discount rate for valuing investments that are more risky?
I don't understand the bold text. In particular: "if some risk is incurred resulting in some losses, then a discount rate in the NPV will reduce the effect of such losses below their true financial cost". What does this mean?