What Is Risk Premium? A Beginner’s Guide to Understanding Investment Risk
Written by
John Csiszar
Edited by
Nupur Gambhir
Commitment to Our Readers
GOBankingRates' editorial team is committed to bringing you unbiased reviews and information. We use data-driven methodologies to evaluate financial products and services - our reviews and ratings are not influenced by advertisers. You can read more about our editorial guidelines and our products and services review methodology.
20 Years
Helping You Live Richer
Reviewed
by Experts
Trusted by
Millions of Readers
Understanding what a risk premium is, and how it works, is a tricky business, but it’s important. Essentially, a risk premium is the amount of money that an investment can be expected to return above the return on a risk-free asset. But nothing is free in the investment world. In exchange for this potential for excess return comes excess risk. For some investors, the tradeoff is well worth it. But others might be more risk-averse. To help you find out where you fall on the scale, here’s all that you need to know about risk premiums.
Understanding Risk Premium
What Is a Risk Premium?
Simply put, a risk premium is the extra return investors expect for taking on risk. Assets have different risk premiums because investors demand to be compensated for taking on extra risk.
A U.S. Treasury bill, for example, is often considered to be the safest investment in the world. Investors can rest assured that if they hold a U.S. Treasury bill to its maturity date, they will be paid in full. This means that U.S. Treasury bills carry no risk premium. However, they also offer lesser returns.
The U.S. stock market, on the other hand, offers no financial guarantees. You could theoretically lose your entire bankroll if you buy a stock that goes bankrupt. That means you are taking on considerably more risk if you invest in stocks than in Treasury bills. If the average return of the stock market was the same as what you could earn on a Treasury bill, no rational investor would ever buy stocks. This is where the risk premium comes into play. The stock market offers a higher risk premium in order to entice investors.
How Risk Premiums Influence Financial Decisions
The delicate balance of risk and reward is what informs all investment decisions, from the stock market to the bond market to real estate and beyond. Although each person has a different tolerance for risk, the goal of investing is to eke out the highest return possible while taking on the lowest amount of risk. One investor might be comfortable risking losses of 20%, 30% or even more by investing in high-growth stocks in exchange for the potential doubling or tripling of their money. Other investors might prefer solid, “boring” blue-chip stocks that might only return 5% to 8% per year but offer less volatility and consistent dividends, for example.
Valuing individual companies involves factoring in risk premiums as well. Under the Capital Asset Pricing Model, for example, a company is said to be worth the present value of its future cash flows. This amount must then be discounted by the amount of risk inherent in the company itself. Common company risks include economic risk, financial risk, operating risk, product risk, market risk, legal risk and many others. The sum total of all these risks dictates how much of a premium an investor will demand to buy the company’s stock.
Risk Premium Example: Real-World Scenarios
Investments that offer risk-free rates include savings accounts and CDs, which pay modest amounts of interest in exchange for FDIC insurance.
Bonds are a bit riskier than savings accounts and CDs, but are less risky than stocks.
Corporate bonds have higher risk premiums than government bonds or savings accounts because they are only backed by the financial capacity of the individual companies, not the financial strength of the U.S. government or FDIC insurance.
Real estate offers a mid-level risk premium as it is generally viewed as a conservative investment but it can be highly illiquid, which carries its own risk.
Types of Risk Premiums Explained
Equity Risk Premium
The stock market is the long-term champion when it comes to average annual returns, and this makes it a popular investment. However, it’s also subject to wild swings, which is why the equity risk premium is among the highest in the investment world. The nature of the stock market is unpredictable, which is why people who take bigger risks potentially stand to gain bigger rewards through equity risk premium. However, the reverse is also true. Taking risks can cost you money if your investment suddenly goes south.
Investing in the stock market and cashing in on excess equity risk premiums is tempting. But there’s no guarantee of big returns, regardless of what Wall Street’s best analysts predict. Over the long run, the S&P 500 has returned roughly 10% per year. However, it regularly sells off by 10% or more in what’s known as a correction. Bear markets, in which market indexes drop at least 20%, also occur with regularity. As these times can be emotionally trying, investors require that higher risk premium to remain invested.
Those who purchase conservative investments, like CDs or bonds, take less risk than those investing in the equity markets, and they will likely earn less money in return. But their chances of losing a fortune also are minimized.
Where you fall on the risk/reward spectrum, combined with your long-term investment objectives, will dictate whether you should own more stocks, bonds, or other investments entirely.
Credit Risk Premium
While it’s common to compare risk premiums between different asset classes like stocks and bonds, it’s also important within the same asset class. Although the bond market is often described as if it is a singular entity, the truth is there are all kinds of different types of bonds, from the very conservative to the very risky. And the lower the credit rating of a bond, the higher the risk premium it carries.
As described above, for example, Treasury bills have no risk premium at all. In fact, they are the very embodiment of what a risk-free asset is. But high-yield bonds, also known as “junk” bonds, can carry nearly as much risk as an individual stock, and perhaps even more in some cases. High-yield bonds are issued by companies in poor financial condition with weak balance sheets that may not be able to make all their interest or principal payments. By definition, this makes them highly risky. As a result, high-yield bonds carry a high, equity-like risk premium.
Market and Country Risk Premiums
Investors now have the luxury of buying stocks or bonds from companies and governments across the globe. And as you might expect, each individual market carries its own risk premium. While the term “government bond” sounds safe and secure — and it is, in the case of securities issued by the U.S. Treasury — that’s not always the case across the globe. Countries with less-developed economies, for example, don’t typically have the financial strength of most first-world nations, making it riskier to invest in their bonds. The same is true for countries that are undergoing political instability. In both of those scenarios, investors will demand higher risk premiums to invest there.
Factors That Influence Risk Premiums
Risk premiums are not set in stone. Rather, they fluctuate based on a number of outside factors.
For example, higher interest rates and higher inflation create an uncertain economic environment, so equity buyers will demand a higher risk premium to invest in the risky asset class. The same is true in a highly volatile market — as the risk to invest in the market increases, so too does the equity risk premium.
Market sentiment can also play a role in the size of the risk premium. When the market seems to go up steadily every day and investors become complacent, the equity risk premium shrinks because there appears to be less risk in the market. The same is true when companies are reporting healthy earnings growth and the economy seems to be firing on all cylinders. During a recession and/or bear market, however, investors are less interested in the stock market, and the equity risk premium inflates correspondingly.
Calculating Risk Premium: A Simple Formula
The basic risk premium formula is straightforward:
- Risk premium = expected return – risk-free rate
Imagine that an investor is choosing to invest in either a U.S. Treasury bill or a high-growth stock like Nvidia. The risk-free rate on a U.S. Treasury bill is 4% annually, while the investor expects that Nvidia could return as much as 40%. Under this scenario, investing $20,000 would generate an $800 return on the Treasury bill and an $8,000 return on Nvidia stock.
Using the formula above, the risk premium is 36%, or $7,200. The size of this potential excess return should be an indication to an investor that buying Nvidia stock involves a high level of risk.
Investors can and should use various tools and resources to estimate risk premiums. These can include college courses, online resources like the Corporate Finance Institute, and consultations with a fiduciary financial advisor.
Can Risk Premium Be Negative?
Negative risk premiums are rare. However, there are times when high-risk assets like stocks produce lower returns than low-risk assets like Treasury bills. This scenario is known as a negative risk premium. It can be a difficult time to invest, because you are essentially taking on all of the risk for a lesser return.
For a deeper explanation of the negative risk premium, refer to this article from FS Investments.
