The ABCs of Risk Premiums
Investing in the financial markets is inherently risky. There’s never a guarantee you’ll make a certain return on your investment or even that you’ll get back what you put in. Of course, some investments are riskier than others, but they tend to offer potentially higher rates of return. That difference in expected return for riskier investments is called the risk premium. It’s the investor’s reward for taking greater risk. To better understand risk premiums — what causes risk and why risk premiums are important — let’s take a look at the anatomy of an investment’s return, which has three components:
Inflation — Inflation is the rate at which prices increase, typically hovering between 2% and 4%.
Risk-free rate of return — A risk-free rate of return is the return on an extremely low-risk (so low it’s termed risk free) investment. Typically, investors look at the short-term interest rate on a Treasury bill (T-bill) as a risk-free rate. Investors view the backing of the U.S. government and their short maturity as signs of the investment’s stability and liquidity; in other words, low risk.
Risk premium — The third component of an investment’s return is the risk premium. On short-term T-bills, the risk premium is zero — those investments are considered risk free. But other investments, including stocks, have added elements of risk. A risk premium is the excess return of an investment that is greater than the risk-free rate of return.
What Causes Risk?
Broadly, there are three reasons that some investments are more risky than others:
Returns on stock investments can fluctuate, unlike predictable bond coupon payments.
Corporate bond holders have the first claim to corporate earnings before stock holders, who have a residual claim.
Stock returns tend to be more volatile.
Historically, bonds and cash equivalents tend to be less risky than stock investments. But even among stocks, risk premiums vary. A company with historically stable stock returns, a long earnings history, and a conservative growth plan will likely have a lower risk premium than a new company that’s growing quickly and aggressively.
Why Are Risk Premiums Important?
Understanding risk premiums is the first step in creating an asset allocation plan for your investments. To determine which assets to invest in, you’ll have to determine the optimal risk-premium mix for you. Some investors tolerate risk quite well, while others do not. You need to honestly assess your risk tolerance level, so you can determine the amount of risk that best suits your particular needs.
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