When investors decide on which security to put their money into, it usually depends on whether its expected return is enough to make up for the level of risk they are about to expose themselves to.
That extra return is known as the risk premium in the financial space. In a nutshell, risk premium indicates how much the investor needs to be compensated for taking the risk of an investment. So the riskier the investment, the more return the investor will require.
Risk Premium Explained
The risk premium is a rate of return you could receive from riskier assets such as stocks. Compared to the guaranteed rate of return in risk-free investments such as government bonds, the risk premium is usually higher.
Investing will always expose you to the unavoidable risk of losing money. Stock prices could drop sharply due to different reasons, like weakness in the overall market, poor financial performance, or issuer negligence.
No investment is entirely risk-free, although some US debt securities are nearly risk-free.
For example, US Treasury bills and bonds are considered risk-free since the likelihood of the US government defaulting is almost zero. Still, while Treasury bills are low-risk, their rate of return is also lower than other types of investments.
Additionally, foreign bonds can carry low risks, but it would depend on the country’s creditworthiness.
Blue-chip companies’ investment-grade bonds with a AAA rating can fall under the risk-free asset category. However, they are not 100% risk-free because companies can theoretically default on their payments.
On the other hand, stocks are often seen to be riskier than other assets, although their risk levels can differ greatly, depending on the issuing company.
So when you put money into assets like stocks, you’re also facing the risk of losing that money. That’s where risk premium plays an important role. As the risk-return tradeoff implies, the more risk you take, the higher your potential return will be.
Therefore, investing in riskier assets increases your odds of turning a bigger profit, which potentially provides the return you need in exchange for risking more investment dollars.
Calculating Risk Premium
Calculating the risk premium is pretty simple. You only need to subtract the estimated return on the given asset from the return on the risk-free investment.
Risk Premium = Asset’s Estimated Return – Risk-Free Investment’s Rate of Return
Equity Risk Premium and Mark Risk Premium Explained
Risk premium can be classified in two ways: the equity risk premium and the market risk premium, which are both forward-looking theoretical tools.
Equity risk premium represents the additional return you expect to make on holding individual stocks. The premium you can receive is directly linked to the stock’s risk. Therefore, a stock with higher risk will need a higher equity risk premium to attract investors.
The equity risk premium formula involves subtracting the expected return on stocks from the expected return on safe bonds.
Meanwhile, the market risk premium represents the additional return you expect to make on holding a risky market portfolio instead of a risk-free one. The market risk premium is determined by subtracting the estimated equity market return from the risk-free rate.
The Relationship Between Capital Asset Pricing Model and Risk Premium
The capital asset pricing model, or CAPM, let investors see how an investment’s risk premium may affect its expected returns. The CAPM implies that not all risks should influence an asset’s price, considering that some risks can be distributed among different securities.
The risks for similar assets tend to be correlated, as broad economic trends affect similar investments in nearly the same ways. Such occurrence is known as systematic risk or total market risk, which is a risk that you can’t minimize through diversification.
On the other hand, non-systematic risk, which varies on every individual security, can be managed by spreading it across your portfolio of investments.
CAPM shows investors the relationship between systematic risk and estimated return. In the model, the standard measure of a stock’s systematic risk is called the beta. The beta gauges the stock’s volatility in comparison to the overall market.
The beta of a stock can be found through published sources. Still, you can try calculating it yourself by dividing the stock’s standard deviation of returns by the benchmark’s standard deviation of returns. The next step is to multiply the result by the correlation of the stock’s and the benchmark’s returns.
A beta above one suggests that the stock’s price has a tendency to be more volatile than the market, while a beta below one indicates that the price can be less volatile than the market. A beta of one means the stock’s price tends to move with the market.
To sum it all up, the CAPM needs three things to determine a stock’s expected return: the risk-free rate, market risk premium, and beta.
The Importance of Risk Premium
Investors can use risk premium and CAPM to back their decisions, including asset allocation. In addition, several financial websites can provide the stock betas and past market return figures you need, while the US Treasury has data on government bond rates.
You also don’t necessarily have to calculate the risk premium yourself, as some data providers can provide you with historical and existing equity risk premiums.
Stocks often become more attractive when the equity risk premium is higher, but investors typically choose fixed-income securities when the equity risk premium is lower.
That can be vital information when you’re trying to find out a way to pick to allocate money in your 401(k) to stocks and bonds. For example, if you’re going through individual stocks, the CAPM can tell your looking at individual assets while putting emphasis on the part played by risk in estimated return.
Still, keep in mind that equity risk premium and the CAPM are theoretical tools based on past performance readings, and a historical performance can’t exactly ensure the results in the future.
Perhaps the best way is to treat equity risk premium and CAPM as two of your investment analysis tools that would inform your decision-making.
