How to Calculate Risk Premium
Risk and reward: They're two sides of the same coin in almost every situation and that's the way it's supposed to work for stock investors, too. When you assume the risk of investing in a stock, you should be able to expect a reward that's commensurate with the risk. The greater the risk, the more you should earn.
The problem with the relationship between risk and reward is that the reward is always a potential reward. The rewards for investing don't take place in the here and now and they're never completely guaranteed.
Investors have to figure out what their reward should be so they can invest accordingly but there's a quick and easy way to get a reading on an investment's potential reward to assess the risk you're taking.
The First Step
The first step is to determine the "risk-free" return that's currently available in the market—an investment you could own that is without risk and that serves as a baseline for your measurement. Many investors use U.S. Treasury bonds for this benchmark because they're backed by the full faith and credit of the U.S. government.
If you can earn a risk-free return of 2 percent from Treasury bonds, that becomes your baseline. This means that any investment with risk must return more than 5 percent to be worthwhile. The amount the investment returns over 2 percent is known as the risk premium.
The risk premium is 9 percent if you're looking at a stock with an expected return of 11 percent: 11 percent less 2 percent equals a 9 percent risk premium.
Is It Enough?
Ask yourself if 9 percent is enough of a risk premium for the risk that this particular stock you're considering might not achieve the return you expect. It probably is—at least for a well-established, large-cap stock. But it might not be enough of a risk premium to justify the risk you're taking with the investment on a young, small-cap stock.
This simple test is not the only analysis you could or should do and there might be other factors involved. The lesson here is that you should always ask yourself if the risk premium for a particular investment makes it worth wagering your money on that particular stock—or any investment for that matter.
There's also a factor that's not quite quantifiable, at least numerically. Your own aversion to or tolerance for risk should be considered as well. A 9 percent risk premium might be more or less than you can comfortably stomach.
Jacara does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.