What is a Risk Premium?

A risk premium is like getting college credit for taking advanced placement (AP) classes…

Think back to high school, when you were offered the chance to take AP classes. If you took the class and did well on the AP exam, you could get a head start by earning some college credit. But there’s also more risk. These classes are more difficult, and if you did poorly, it would negatively affect your GPA. Similarly, a risk premium compensates investors for taking on greater risk with a greater financial return.

A risk premium is the extra return an investor requires for putting their money into higher-risk investments. The risk premium of a particular investment is the difference between its return and the return of a theoretical risk-free investment (typically government securities considered to be ‘risk-free’ because the federal government backs it).

Suppose a friend of yours was creating a new startup company and asked you to get in on the ground floor as an investor. You know that investing in startups can be risky. But you also know that if the company takes off, you might see a huge return. Because you know the return could be significantly higher than the risk-free rate, you’re willing to give it a shot.

A risk premium is the difference between the return of a particular investment and the risk-free rate of return. Risk premium can apply to any type of investment that carries a greater level of risk, and therefore a greater return, than a US Treasury security.

Equity risk premium specifically refers to the added return an investor requires for investing in the stock market. In general, investing in stocks has a greater level of risk compared to buying US Treasury securities. Because the companies in the market don’t guarantee their stock returns, investors always have a chance of losing their money. Equity risk premium refers to the return differential between an equity investment (aka buying stock) and the risk-free rate.

The equity risk premium of different stocks varies significantly. Suppose you had one investor that put their money into an S&P 500 index fund (a fund that tracks the performance of some of the 500 largest companies in the market). At the same time, another investor put all of their money into the stock of a single tech company. The latter investment probably comes with more risk, and therefore might have a greater equity risk premium.

A risk premium is the greater return an investor would likely expect above and beyond that of a risk-free government security. It’s a way to compensate investors for taking on extra risk. Calculating the risk premium of a particular investment requires finding the difference between the return of an investment and the risk-free rate of return. While the math itself is simple, quantifying some of the factors may be a bit more challenging. That formula looks like this:

Risk Premium = Rate of Return - Risk-Free Rate of Return

Suppose someone bought shares of stock in their favorite company. We can figure out their risk premium with the calculation above (using purely fictional data). Suppose they saw a return of 8% over a one-year period. Now let’s say that during that same year, the rate on a US Treasury security was 2.25%. By subtracting the 2.25% risk-free rate from the 8% actual return, the investor ends up with a risk premium of 5.75%.

Risk premium is a number that can fluctuate often as a result of changing interest rates and stock market returns. During the several years leading up to 2020, the stock market saw returns around 8%, with a risk premium of about 5%. And while those numbers may have been normal over the past five to 10 years, they aren’t entirely to be expected.

According to economists in the Financial Analysts Journal, the 5% risk premium that’s existed in recent times isn’t the norm. In fact, they argue that 5% is an unusually high premium, and that investors shouldn’t expect to see the same premiums consistently in the future.

That being said, risk premiums can vary significantly depending on what you’re talking about. Those referring to risk premium often compare stock market returns to the risk-free rate. But you can also calculate the risk premium of everything from real estate to commodities (which are physical materials such as oil or gold).

A negative risk premium occurs when a particular investment results in a rate of return that’s lower than that of a risk-free security. In general, a risk premium is a way to compensate an investor for greater risk. Investments that have lower risk might also have a lower risk premium. In some cases, the return of a particularly low-risk investment might have a negative risk premium.

And it isn’t just low-risk investments that can have a negative risk premium. During the 20-year period from 1963 to 1983, the stock market had a negative risk premium. In other words, investors were seeing worse returns by investing in a risky investment.

There are many ways someone might try to calculate a risk premium. Someone might use simple data to calculate current or past premiums. An implied risk premium, however, is a way of predicting the future. When someone calculates implied risk premium, they are trying to use current data and a few assumptions to estimate what the expected risk premium will be at a particular point in the future.

Calculating implied risk premium requires data such as an investment’s current price, its estimated future cash flows (meaning the expected gains), and a discount rate. A discount rate is necessary to account for the fact that money in the future is worth less than the same value of money if you had it today (aka the time value of money).

There are several different ways that investors and analysts can calculate a risk premium. They might use current data to try to estimate the current risk premium. They also might use current and past data to try to figure out what the risk premium will be in the future. Finally, they might use historical data to figure out the historical risk premium (aka the historical average of realized returns).

To pin down the historical risk premium, one would have to know the average return rate of the market for a specific period. Data for this formula often relies on the average returns of the S&P 500, which is a market index of some of the 500 largest companies in the stock market. They’d also need the average US Treasury rate for that same time. Calculating historical premiums is far simpler than estimating future premiums, as there’s no guesswork required.

Suppose you wanted to calculate the historical risk premium for the 25 years leading up to 2020. During those years, the S&P 500 saw an average return of 9.74%. For that same period, the average 10-year Treasury rate was 3.8%. To calculate the risk premium for this period, you’d use the following formula:

Average S&P 500 Return of 9.74% — Average Risk-Free Return of 3.8% = Historical Risk Premium of 5.94%

It’s important to note that this data relies only on the returns of the S&P 500. Because everyone’s portfolio is invested differently, this number wouldn’t apply to every investor. Each individual could find their own historical risk premium using the historical US Treasury rate and their own market returns.

Market risk premium is a number that’s constantly changing as a result of what is happening with the economy.

2020 was a particularly interesting year, as the stock market saw some of its record high days, as well as some substantial losses after COVID-19. Interest rates changed dramatically as well, as the Federal Reserve Bank dropped rates after the pandemic hit.

With all of the volatility the past year saw, the average market risk premium in 2020 was about 5.6%, which is close to the average for the previous 25 years combined.