What is the risk premium?

A risk premium is the amount of return you need to earn before risking an unsecured investment versus a guaranteed investment. This is a very important factor that investors consider when choosing the best way to allocate their limited resources. Of course, in many cases this risk premium is theoretical. Very few can have a risk premium set in their minds, or at least refer to it in those terms.

This risk premium can also be described as the return you would expect to get on market safety, versus the kind of return you might get from a more risk-free investment. In the case of a risk-free investment, this usually means an interest rate paid on something like US Treasuries or some other type of guaranteed investment. Of course, even these investments are not fully guaranteed. If there were a catastrophic bankruptcy of the financial institution or the federal government in the case of treasuries, all would be lost. Of course, any cash assets would quickly become useless under these circumstances.

For stocks, the return on investment is calculated considering two factors: the payment of dividends, which can occur every quarter, along with capital gains. Capital gains are only realized when a share is sold. Many may not take these two issues into account when analyzing a risk premium. When equities are considered, this is sometimes called the equity risk premium or equity risk premium.

For bonds, risk, sometimes called 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 almost all cases, the bond will earn a higher interest rate. Otherwise, there would be no reason for any investor to consider them as an option.

To calculate a risk premium, simply consider the return on investment of a guaranteed investment versus a riskier one. For example, if a US Treasury bond yields 3% and the expected rate of return on a stock is 8%, the risk premium would be 5%: eight minus three. Whether that risk is worth it is a question for the individual investor, who may also want to consult an investment adviser before making this decision. The amount of risk someone is willing to take can change based on investment goals or life circumstances, so this can be relatively fluid.

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