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What is Risk Premium?
A risk premium is the amount of return one needs to realize before taking a chance with an unsecured investment versus a guaranteed investment. This is a very important factor investors consider when choosing how best to allocate their limited resources. Of course, in many cases, this premium is theoretical. Very few may actually have a set risk premium in their minds, or at least refer to it in those terms.
This risk premium can also be described as the return one expects to make on the market security, versus what kind of return they can make on a more risk-free investment. In the case of a risk-free investment, this usually means an interest rate paid on something like US Treasury bonds or some other sort of guaranteed investment. Of course, even these investments are not guaranteed completely. If there was a catastrophic failure of the financial institution or federal government in the case of treasury bonds, all would be lost. Of course, any cash assets would quickly become worthless under those circumstances.
For stocks, the return on investment is calculated by looking at two factors -- the dividend payout, which can come as often as every quarter, along with the capital gains. The capital gains are only realized when a stock is sold. Many may not factor in both issues when looking at a risk premium. Where stocks are considered, this is sometimes referred to as equity or stock risk premium.
For bonds, the risk, sometimes referred to as the bond risk premium, can be determined simply by looking at the difference in interest rates between what the bond will yield and what the guaranteed investment would be. In nearly all cases, the bond will yield a higher interest rate. Otherwise, there would be no reason for any investor to consider them as an option.
To calculate a risk premium, one simply needs to consider the return on investment of a guaranteed investment versus a more risky one. For example, if a US Treasury bond yields 3 percent and the expected rate of return on a stock is 8 percent, the risk premium would be 5 percent -- eight minus three. Whether this is worth the risk is a question for the individual investor, who may also seek the advice of an investment adviser before making such a choice. The amount of risk someone is willing to take may change depending on investment goals or life circumstances, therefore this can be relatively fluid.
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![For stocks, the return on investment is calculated by looking at the dividend payout and the capital gains.]()
By: visi.stockFor stocks, the return on investment is calculated by looking at the dividend payout and the capital gains. -
![To calculate a risk premium, one simply needs to consider the return on investment of a guaranteed investment versus a more risky one.]()
By: KurhanTo calculate a risk premium, one simply needs to consider the return on investment of a guaranteed investment versus a more risky one.
Discussion Comments
Is it possible for the risk premium to be negative before an investment is undertaken?
Can we ever gain a benefit from investing in a asset that has a negative risk premium?
@Suntan12 - I agree and I have to say that the risk model really changes from time to time. There are some investments that were traditionally considered safe bets that are now pretty risky.
For example years ago, municipal bonds were considered a safe way to invest your money and get guaranteed tax free dividend income. However, with the amount of municipalities that have gone bankrupt these days makes these seemingly safe investments somewhat volatile and not the safe bet that they used to be.
I think that the risk model for these investments has changed dramatically because the debt risk premium is too high. Many people wonder if the municipalities will be able to pay back the investor because so many cities and states are literally bankrupt.
@Bonij- I agree that stocks can be a bit volatile at times but over the long haul this category of investments usually offers the highest rates of return. There is a market risk premium that you have to consider, but if your long term investing horizon is longer than five years you should be able to minimize your risk considerably.
However, if you are looking for a short term investment of less than five years then maybe stocks are not for you. You also have to consider the percentage of your portfolio that would be invested in stocks.
If the for example, you are in your fifties and you have 90% invested in the stock market then the size of the risk premium might be too great to continue with that ratio. You might want to consider fixed annuities or other safer investments and have a much smaller portion of your portfolio in the stock market.
When considering whether to buy stocks, you need to look at the risk premium. Your rate of return on a stock includes the dividend, which is given out quarterly and the capital gains, which is calculated after the sale of a stock.
An investor may not receive the expected amount from his stock investment. There are so many factors that control the stock market. An investor must weigh everything and then decide if he wants to take the risk to possibly earn more or the guaranteed investment that yields less profit.
If you are in a situation where you cannot take any risk with your money, you should probably avoid investing in stocks. This might be anyone who is retired and is on a fixed income, with little retirement money.
Say you are younger and can tolerate some risk, you could compare the rate of return in various stocks with the amount you would be guaranteed to get through a guaranteed investment in treasury bonds, for example. So you have to look at the whole picture before you use risk premium choices.
It really comes down to how much you can afford to lose, when considering riskier investments. If you can't afford to lose some or all of your investment money, you should probably stick to treasuries and other low-risk alternatives. However, if you can recover the potential loss, why not roll the dice a little and go for the larger return.
It may help to think of risk premium in terms of hazard pay for your investments. The risk free rate could be viewed as an average job with low risk of injuring one's self.
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