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Educational Post
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.
