Key Takeaways

  • Risk premium is basically the extra return you expect when you choose an investment that’s riskier than just keeping your money somewhere safer.

  • There are different types of risk premiums depending on things like market volatility, the chance a borrower won’t pay back (default risk), or how hard it is to sell an asset (liquidity).

  • Understanding risk premiums can help investors sort out which investments might be worth it, based on their investing style and risk profile.

Introduction

Investing is all about trying to get a good return without taking on more risk than you can handle. Some assets are considered safer than others, like government bonds or gold. On the other hand, investing in things like stocks, cryptocurrencies, or real estate usually means accepting higher risks.

Risk premium is a handy idea that helps guide investors as they look for ways to grow their money while keeping an eye on potential risks.

Risk Premium Explained

When you put your money into riskier options, there is a natural expectation of better returns. That extra bit you’re hoping to earn, compared to a safe investment, is what we call the risk premium. It’s basically the gap between what you hope to earn from a risky investment and what you could earn from a safe one.

For example, in the US, government Treasury bonds are considered safe because the chances of a government default are low. If you decide to buy into something less predictable, you want to get paid more for taking on that risk. The difference in potential returns between the safe bet and the riskier choice is the risk premium.

If a US bond pays 2% interest and a company bond is offering 5%, the risk premium is 3%. The company has to offer you more because there’s a real chance they could miss a payment or even go out of business.

Why the Risk Premium Matters

The main reason investors care about risk premium is because it helps them compare options. It’s not always smart to just go for the highest return; you have to weigh how likely you are to actually get that return—or lose money.

Risk premium is also important in models that professionals use, like the Capital Asset Pricing Model (CAPM), which helps estimate how much return an investment should ideally give when you consider its risk level.

On top of that, thinking about risk premiums can encourage people to diversify, or spread out, their investments. By having a mix of assets with different risk premiums, you can try to strike a balance between aiming for bigger returns and not exposing yourself to unnecessary risk.

Types of Risk Premiums

There are different reasons why investors want extra reward for taking risks, and so there are different types of risk premiums. 

For instance, the equity risk premium is the extra return people expect when they buy stocks instead of sticking with safer options like government bonds. Stocks generally swing up and down more, so the premium can be bigger.

Then there’s something called credit risk premium. That’s the added reward for lending money to borrowers that might not pay you back, like a company or a country with shaky finances.

Another kind is the liquidity risk premium. Some things you invest in, like certain real estate or rare collectibles, aren’t easy to sell on short notice. To make it worth your while, those investments might need to offer a higher expected return.

Cryptocurrency risk premium

Cryptocurrencies come with their own kind of risk premium. Because the crypto market is still fairly new and can be very volatile, investors usually expect higher potential returns compared to traditional investments like stocks or bonds.

While bitcoin is considered the safest option, altcoins tend to bring much higher risks. Things like price swings, changing regulations, rug pulls, hacking risks, and shifting narratives all add more uncertainty to crypto investments.

How to Calculate the Risk Premium

Working out the risk premium is pretty simple. You just subtract the return you could get from a safe investment (like a government bond) from the expected return on the riskier choice. For example, if you think a stock could return 8% a year, and a government bond pays 3%, the risk premium would be 5%.

This number isn’t set in stone. How big or small the premium is can change a lot, depending on what’s happening in the markets, how investors are feeling, and what makes the investment special or unusual.

What Can Impact the Risk Premium?

Risk premiums go up and down all the time. Things like the overall health of the economy or a sudden shock to the markets can make investors want more compensation for risk—or sometimes they’re willing to settle for less. When uncertainty is higher, the risk premium tends to increase. When things seem stable or everyone feels confident, the risk premium can shrink.

It also comes down to details about the investment itself. Investments that are new to the market, difficult to sell quickly, or very volatile usually have bigger risk premiums. Big news or macro events can also have an immediate impact on risk premiums across an entire industry or country.

Closing Thoughts

Understanding risk premium is helpful for anyone trying to make smarter investment choices. Knowing what it is, how to calculate it, and what might cause it to change gives you a better shot at building a portfolio that matches your goals and how much risk you can handle. 

At the end of the day, the risk premium reminds us that if you want a shot at bigger returns, you’ll almost always have to take on some extra risk. The trick is to figure out when that trade-off makes sense for you.

Further Reading

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