Investing comes with a certain amount of risk. Some investments, like the equity market, are riskier than other assets like U.S. government bonds. Understanding that risk can help investors make the right choices for them when it comes to asset allocation.
But how do you know how risky something is? That’s where risk premium comes it. Risk premium is the return expected by an investor in exchange for putting their money on the line. Knowing the risk premium can help you decide which stocks and ETFs to invest in.
What is a risk premium?
Risk premium is the expected return required by an investor in exchange for putting their money into high-risk investments.
In other words, the riskier the investment, the more return an investor needs to hold the asset in their stock portfolio. It’s the payment investors receive in exchange for putting their money in a high risk investment instead of a “risk-free” investment like U.S. Treasury bonds.
Table of Contents:
- What is a risk premium?
- Types of risk
- How is a risk premium calculated?
- Example of a risk premium
- Market risk premium vs equity risk premium
- Why would an investor consider or avoid a risk premium?
- How to avoid buying risky stocks on Public
Types of risks
There are about five risks associated with the risk premium that investors should keep in mind. All of these risks can hurt an investor’s bottom line, which means an investor should make sure their risk premium is adequate before they invest.
With the Public app, Safety Labels warn investors of potential risky stocks and exchange traded funds so you can stay safe and aware of any risk you are taking with your money.
Business risk is the risk of not knowing the future financials of a company, such as its cash flow and operations. Cash flow can vary from one quarter to the next, which can lead to a lot of investor uncertainty about the performance of a company.
A company that has had stable cash flows over the last few years might need less of a premium than a company whose cash flow varies from one year to the next or has seasonal cash flow. The more volatility at a company, the more risk premium investors require.
Financial risk refers to a company’s ability to manage its financing. In other words, can the company pay its debt obligations? The more debt a company has, the more risk there is that it could go under. Companies that have equity and no debt have no debt obligations and therefore very little financial risk. Companies with debt have more financial leverage, which increases the chance the company might not be able to pay off its debt.
Liquidity risk is the risk of an investor not knowing when they will be able to exit an investment. Exiting an investment immediately depends on the type of security or asset held. A blue-chip stock is easier to sell because it’s in higher demand, while a stock from a company that is not well known might be harder to exit from.
Exchange-rate risk is the risk of investments in a currency other than the currency of the investor. An American investor who buys stock of a French company that is denominated in euros will have more volatility associated with the exchange rate, as the rate can change at any time. The more variation between the currencies, the more compensation or premium risk demanded by investors.
An investment made in a country with political and economic uncertainty will face greater risk than in a country with a steady political environment. Risks can include regime change, policy changes, economic collapse, and war. The U.S. and Canada are low country-specific risk places because they tend to have a more stable nature, while places like Russia or Venezuela pose a greater risk due to their political and economic turmoil.
How is a risk premium calculated?
The equity risk premium or ERP is the return that an investment in the stock market will give an investor compared to a risk-free rate. The amount of return depends on the level risk.
You can find out the risk premium by subtracting the return on a risk-free investment from the return on the investment.
Risk Premium = Rate of Return – Risk-Free Rate of Return.
Example of a risk premium
Let’s say you want to invest in Company ABC. You can calculate the risk premium of the company using the above formula. Let’s say the company had a return of 8% over the past year. During that same period, let’s say the rate on a U.S. Treasury was 2.75%. If you subtract the risk-free investment from the expected return, so 8-2.75, you get a risk premium of 5.25%.
Now let’s say there is another company, XYZ, that had a return of 25%. Using the same formula, you discover the risk premium is 22.25%. You do some digging and discover that Company ABC is a stable, blue-chip stock with relatively stable share price. But XYZ has a lot of price swings and is more volatile. So investors need a higher promise of a return, called the risk premium, to compensate for potential losses.
Market risk premium vs equity risk premium
A market risk premium is the expected return on an index or portfolio, while an equity risk premium is a return from just stocks. An equity risk premium is often higher than a market risk premium, as a market risk premium can include other assets like bonds, currencies, and commodities.
Both returns use the U.S. Treasury government bond as a benchmark since Treasuries are considered risk-free compared to other types of investments.
Why would an investor consider or avoid a risk premium?
You should always be aware of the risk you are taking when investing in a market portfolio. The risk premium helps you understand the potential risk of your stock allocation as well as the potential reward. If you are okay with taking the risk of losing your money in exchange for a potential higher stock returns, then investing in risky assets with a high risk premium might make sense for you.
But if you want to try to avoid losing your funds, then investing in more conservative assets or less risky investment might make more sense. In that case you might consider investing in stocks or ETFs with a lower risk premium. Of course it’s also important to understand that past performance doesn’t guarantee the same returns in the future. There is always a bit of risk with any type of investment.
How to avoid buying risky stocks on Public
The risk premium can help you know how much risk you are taking in an investment and can help you decide if the amount of potential return is worth it.
At Public, we have implemented Safety Labels on riskier stocks and ETFs to help you keep your money safe and understand when you are taking on a risky investment.
You can also get insight into potential investments with Public Premium, including insights on a company’s cash flow, operating expenses, growth, revenue segments, and more. You also get access to exclusive news and articles from research firm Morning Star.
This information can help you decide if the risk premium of an investment makes sense for your portfolio.
Frequently asked questions
What is the risk premium formula?
The risk premium formula is Risk Premium = Rate of Return – Risk-Free Rate of Return.
What is risk premium in CAPM?
CAPM is the capital asset pricing model, which looks at how an expected return is influenced by the risk premium of an investment.
Is a higher risk premium better?
A higher risk premium is not always better, as a high premium means that an investor is taking on more risk. While an investor may potentially expect a higher return with a high risk premium, it also means that there is a higher risk of losing your money.
What are the three types of risk premium?
There are actually five types of risk premium – business risk, financial risk, liquidity risk, exchange-rate risk, and country-specific risk.
Why is it called risk premium?
A risk premium is another word for excess return that an investor can expect in exchange for the level of risk taken on.
What is the difference between cost of equity and cost of debt?
The cost of equity is the rate of return expected by shareholders while the cost of debt is the rate of return expected by bondholders.